With Marian Ross
AS investors anticipate a rise in interest rates, the first half of the year has seen a tremendous rally in equity markets and oddly enough, in fixed income markets as well.
The 10-year US treasury (UST) yield started the year at around three per cent. Between June and September 2013, bond markets sold off as investors priced in the much anticipated interest rate hike.
However, today the yield on the 10-year UST is hovering in the 2.5 per cent range. This could be attribtued to many different things, chief among them the rise in geopolitical tensions in Eastern Europe and the Middle East, as well as the weak performance of the Eurozone economies.
Whatever the cause, investors must equip themselves with instruments and strategies that are dynamic and flexible.
Today we will take a closer look at fixed income instruments that may be very useful during times of rising interest rates. These instruments combine features of debt and equity in order to give investors exposure to the upswing in the equity markets, but also provide the principal safety and income of traditional fixed income instruments.
Once such instrument is an “autocallable”.
Autocallable instruments give the investor a reward if a pre-established condition is met. In most cases, the condition usually stipulates that the price of a particular asset must stay within a specified range for the reward to be dispensed. An important feature of this security is the embedded call option.
The instrument is automatically “called” (ie redeemed) by the issuer if the upper limit of the range is breached.
During the time period when the condition is not in breach and the asset price is within the stipulated range, the holder is usually paid some form of return on his principal, which can take the form of a coupon.
For example, an autocallable may be designed so that if the price of an Apple stock stays within the range of US$99 to US$200, the noteholder will receive a coupon of 8 per cent per annum.
However, should the price exceed US$200, the note will be called by the issuer. Similarly, if the price falls below US$99 on the observation date, no coupon is paid for that period.
Autocallables are usually very short in tenor and therefore help investors to reduce their duration risk.
As discussed in previous articles, staying short is important in a rising interest rate environment.
What makes an
autocallable attractive?
The coupon paid on the note and the range of price movement relating to the reference asset that is stipulated are the key features that determine the attractiveness of an autocallable note. Important questions to ask include: what is the price history of the underlying asset? When did it breach the “barriers” as identified in the terms and conditions of your note? (How often? How long ago?) What are the expectations regarding future price movement?
Be sure that you are convinced of the rationale for the potential movement (or lack thereof) in the price of the reference asset that is linked to the note.
Has a sufficiently compelling argument been presented to you to substantiate the movement that is necessary to generate the coupon payment?
Who issued the autocallable?
As an investor, you should ensure that the issuing company is capable of repaying you and honouring its obligations under the terms and conditions of the security.
For example, an autocallable issued by Barclays Bank will carry a much higher credit rating than any note issued by a local Jamaican bank. Jamaican investors can access the safety and security of the international capital markets right here at home.
When are autocallables a good buy?
It’s important to highlight that the availability of attractive autocallables is unpredictable due to the fact that they are related to spikes in the volatility of the equities market. As interest rates rise, so does volatility. The attractiveness of autocallables is a function of the prevailing environment and market behaviour. As volatility (and interest rates) rise, so will the attractiveness of autocallable instruments. Investors should look out for rises in volatility in the US equity market as a potential signal for attractive autocallables.
Benefits to investors
- Short tenors: These notes can be structured with relatively short tenors ranging from one to five years. This minimises the duration risk associated with the instrument.
- Exposure to reference assets without buying them outright: These notes allow investors to benefit from movements in the price or value of a security without having to purchase the asset outright. In cases where an investor is not comfortable with the prospect of a long term equity purchase but would still like to take advantage of price movement in the short to medium term, autocallables can facilitate this exposure.
- Hedging: For institutional investors, structured notes such as autocallables can be particularly useful because these conditions can be designed as a hedge for your existing asset portfolio / operations.
Marian Ross is Assistant vice president, business development at Sterling Asset Management. Visit our website at www.sterling.com.jm or provide feedback at: info@sterlingasset.net.jm
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As interest rates rise and fall, equip yourself with flexible instruments
