In the U.K. and several other major markets, reverse convertibles, high coupon products financed by a short put option, have been popular in the retail investment arena. Investors are ever hungry for income, dissatisfied with meagre returns from deposit accounts, and have turned in a big way to stock market-linked high income bonds in the last three years. These investments usually have a fixed maturity of between one and five years and pay interest well above risk-free yields - typically 8-11% p.a.. While the income is fixed and guaranteed, the capital is not and is linked to one or more equity indices or stocks. In order for the capital to be repaid in full the equity performance must reach a certain target, for example not falling over the lifetime of the bond.
These products are available in a variety of tax-wrappers but the derivatives components are similar. Because interest rates have stayed at low levels in the last few years there is demand for products which increase income but still provide a reasonable likelihood of a full return of capital. The first issues seen in the U.K. were linked to a single index. The FTSE-100 was the obvious choice but products have also been linked to the Dow Jones EURO STOXX 50 and Nasdaq100 in particular. The more volatile an index the more premium is generated and this boosts the income available. These products became viable not only because interest rates remain low but also because implied volatility levels reached relatively high levels. This has been caused by equity markets becoming much more volatile and also because the many billions of pounds worth of options sold by investment banks in the last decade to underwrite guaranteed stock market bonds have left volatilities high in order to reflect the ongoing risk to the derivatives houses.
The basic construction of all high income bonds works as follows. Suppose that after costs a product provider could issue a bond paying 5% income and with capital guaranteed. On top of this an option is sold--s ome type of put option--which only pays out if the market declines, for which a premium payment is received. Because volatilities are high selling this option generates a healthy premium, typically around 12% for a three-year term. This 12% can be spread over the three years to boost the income by around 4% p.a., which added to the 5% risk-free income provides a total of 9% p.a. Thus the income target is achieved and at the end of the investment period the payment, if any, due on the option is calculated. The whole idea is that an option is chosen which is unlikely to pay out so the usual choice is an option that pays the amount linked to how much the index has fallen over the period. As historical studies show, and as most investors are prepared to believe, the chance of equity markets going down over a medium term horizon, such as three to five years, is quite small (although recent experience is starting to challenge this assumption). Hence there is a very high chance that no payment is made and therefore the investor emerges with all the capital intact plus a high income.
If however the market falls the amount payable on the option is deducted from the initial capital and the investor sees this as a reduced capital payment. Usually the fall in capital is 1:1 with the index - i.e. if the index is down 5% the investor receives 95% of capital, if the index is down 10% the investor receives 90% and so on. Sometimes the downside starts at a different point, for example 90% of the starting level or has a different gearing, such as 2:1.
One might reasonably ask, if these options are unlikely to ever pay out why are investment banks, who are not known for their charity, prepared to pay good money for them. The answer lies in the fact that investment markets have many participants who have different aims and act according to them. The investor of a high income bond effectively sells the option and then sits back waiting for markets to rise. The bank that has bought the option either uses it to reduce risk on its books of previous or future option positions or may actively make frequent equity trades on the back of it.
These investments can have different maturities as well as underlying assets. The shorter the bond life the higher the potential yield since the option premium can be spread over a shorter period - a 12% option premium gives a 4% yield pickup for a three year product but only 3% for a four year one. However a product provider has certain fixed costs and also the longer the investment period the greater the chance the market will perform sufficiently well both of which suggest a longer period is better. The final choice depends on the investor base and the risk profile that a provider wishes to achieve. As with most asset classes, the usual risk-reward rules apply so the higher income sought, the greater the chance of a loss of capital.
In 2001 interest rates have continued to fall and the big success of index linked products has driven the volatility levels back down somewhat. Hence providers have started to market products linked to individual stocks. This is done to generate higher premiums and maintain yields. Either downside risk is taken individually or on a collection of stocks and because stocks are significantly more volatile than the index they comprise more premium is generated. However product design need not stop there and truly multi-asset products have been seen for example products linked to the worst performing 10 out of 30 stocks over a given period. Here correlation as well as volatility considerations make the pricing more complex but undoubtedly increase the option's value.
Because these investments are aimed at the retail market there is clearly a duty to promote responsible products and regulators in the UK and Ireland, where many of these products' vehicles are domiciled, have played their part in trying to ensure this. In particular the poor performances of stock markets over recent months have highlighted a number of considerations.
Firstly, the real nature of the stock market linkage means that capital is not guaranteed and therefore the headline yields have to be viewed against possible capital shortfalls. Secondly, downside risk should not be too highly geared so that losses do not occur too fast if markets fall a good rule of thumb is that the total return on an investment, including income taken, should always outperform a tracker fund linked to the same assets if markets decline. Safety features such as averaging or so-called soft barriers, which mean that capital is not lost if markets do not breach a certain level for example 80% of the strike level, are valuable. If single stocks are used, care must be taken as to their choice and the possible capital losses in various scenarios.
Source: Future Value Consultants
This week's Learning Curve was written by Tim Mortimer, managing director of Future Value Consultants, a software, research, and consultancy firm, in London and consultant to Abbey National Treasury Services.
