Bonus Coupon Notes

Two strong investment themes have emerged in Asia during the last few months. Firstly, Asian investors have remained sanguine with respect to the buoyancy of equities or equity-linked products giving exposure to Mainland China's gross-domestic product and secondly, their confidence in an ongoing economic recovery and improving equity market in Japan. The 30% November to February rally in the Hang Seng China Enterprises Index demonstrates the first of these whilst the Nikkei's appreciation of more than 10% over the same period illustrates the second.

As a result, the market for equity structured notes has remained buoyant throughout Asia with several new structures emerging. Investment themes remain polarized between products offering risk and equity participation and those offering varying forms and degrees of capital protection. Across both types of instruments, investors continue to demand guaranteed yield in order to immunize them from prevailing bank deposit and term rates.

Bonus Coupon Notes provide guaranteed coupons over the life of the note with potential for a bonus coupon based on the underlying asset trading above a specified barrier level. They have replaced much of the range accrual and callable range accrual transactions in vogue last year due to the guaranteed nature of the coupon.

If this barrier level is triggered--it is usually equal to 100% of the spot price at issue--the bonus coupon and the guaranteed coupon are paid and 100% of the principal is redeemed early. If the bonus coupon remains unpaid at maturity, the holder receives 100% of principal if the price of the asset is between 100% and a predefined put level, for example 90%, or, if the asset is below the put level the underlying asset is delivered.

Bonus Coupon Notes will typically suit investors who are moderately bullish the short-term prospects of a particular share or index and who are looking for a guaranteed cash flow. Investors must also be comfortable being put stock at maturity if the asset price is below the put strike.

In this example, Hutchison Whampoa is assumed to be trading at HKD55.00 at issue. The buyer of this HKD100 million face value Bonus Coupon note will receive a guaranteed coupon of 8.88% paid quarterly. They will receive a Bonus Coupon of 5.25% if on any of the quarterly valuation dates Hutchison is trading above the Bonus Coupon Strike of HKD55.00. If this Bonus Coupon is paid the note will be redeemed immediately by payment of the HKD100 million nominal value and any outstanding guaranteed coupon.

If the 5.25% Bonus Coupon is not paid there are two potential outcomes at maturity as represented in Diagram Two below. Firstly, if the Hutchison share price is trading at or above the put strike price of HKD49.50 (but below the Bonus Coupon Strike) the holder of the note receives 100% nominal plus the final quarterly guaranteed coupon. If Hutchison is below HKD49.50, the holder receives the final guaranteed coupon plus 2,020,202 shares.

Bonus Coupon Notes are one of the latest products proving popular with private banks throughout Asia. Their guaranteed coupon and potential for early redemption have been the key attraction for investors and has seen them assume a niche previously held by callable range accrual notes. The Bonus Coupon notes are not without risk however and these risks must be considered before buying.

 

This week's Learning Curve was written by Matthew Long, head of equity derivatives sales at Macquarie Bankin Hong Kong.