Structured Product Valuations: March Results Are Not So Rosy

by: Reid Guenther


Not as many good values in this month's survey.

Still, the results show that there are good values out there.

A terminology is defined to describe the payment features of the structures in this and in future articles.

Compared to last month, my valuations of a sample of structured products issued or to be issued in March are not so good. Only 5 of 16 look like good investments while for the previous month's products, 6 out of 12 were. This is probably due to the more representative sample used this time. The details of that sample will be discussed in the next section. After that, I will cover my results for issuer, historical and scenario valuations and finally conclude with which products I believe represent good values.

The Products

From the SEC's EDGAR search engine, I examined 164 preliminary prospectuses which covered the structured notes registered in the 1st week of March (Feb. 29-Mar. 4). Unfortunately, market-linked CDs do not need to be registered with the SEC, and as I am not aware of a source disclosing their registration, I decided not to evaluate any of those types of structured products. Of the 164 notes I found, 136 were equity-linked, 20 were fixed-income-based while the other 8 were commodity-based or hybrids of fixed-income and equity products. As my valuation software is currently only set up to properly evaluate equity-based products, I focused on the 136 equity-linked structured notes and evaluated 16 products which I felt were a fair representation of the whole.

The chart below shows the 16 structured notes:

Click to enlarge
As you may know, structured products can be divided up into the two basic investment objectives, growth and income. The growth products make a payment at maturity dependent on the performance of the underlying equity, and as you would expect, the income products make regular coupon payments though the amount paid can be contingent on the performance of the underliers. Both types return principal at the end, but there may be losses on the principal repaid depending on the terms of the note which ties the amount repaid to the performance of the underliers. The possibility of loss of principal and changes in the level of the coupons is how these structured products are able to offer enhanced returns, as there really is no free lunch.

Now, as you can see, there are 10 growth, 5 income and 1 growth and income product. For a given investment objective, the products can be further subdivided into 3 categories of principal protection: full principal protection ("PP"), partial principal protection ("PPP") and non-principal protection ("NPP"). As only 5 of the 136 products offered full principal protection, I did not include any of them in my sample. The reason for so few of this type of structured note is probably that investors prefer to buy market-linked CDs which are actually FDIC- insured up to $250k of principal.

This brings up an important point which cannot be overemphasized:

Structured notes are subject to issuer credit risk!

Generally speaking, they are senior unsecured debt of the issuer. Details for each product will be in the respective prospectus which you can find by looking up the product's CUSIP on EDGAR.

Now back to our regularly scheduled programming...

Regarding the payment features shown in the products table, a bit of explanation is in order as I have decided upon my own nomenclature to describe the payment features of the structured notes in this article as well as in future articles. The need for this is that issuers have not yet decided upon a common terminology and tend to use catchy phrases that do not enhance investor understanding.

Dual direction means that the product has a positive return when the underlier return is positive and up to a limit for negative underlier returns.

Digital return means the product is scheduled to pay a set amount in addition to the investor's initial investment when the underlier return meets specified conditions.

Digital minimum return is like a digital except that the return becomes unbounded above a certain return of the underlier.

Buffered means that losses are floored or losses begin at 0% as the underlier return drops below a given level. For the majority of the non-buffered cases, there is a large jump in lost principal when the underlier returns are below a given level.

Capped leveraged return means that the note pays a return at a leveraged rate relative to a positive underlier return, but the maximum return of the note is capped.

Callable means the note is callable at the discretion of the issuer while autocallable means that the note can be called automatically at specified times depending on the performance of the underlier.

Contingent coupon means that the amount of the coupons paid depends on the performance of the underlier.

Range accrual coupon means that the coupon payment in a given period is a multiple of the ratio of the days the underlier is above a given level in a period to the total number of days in the period times a maximum coupon rate.

And the last term, cliquet contingent coupon, means that the condition upon which the coupon paid in a given period is dependent on the underlier's level at the end of the period relative to its level at the beginning of the given period.

Of note, while I use the term underlier in the above definitions, these products actually may depend on the relative performance of more than a single underlier.

Now to the next column, the payment frequency should be self- explanatory. All the growth structures will only have a payment at maturity while the income notes make coupon payments at the indicated periodic increments.

The underlier symbols should be familiar to most (SPX: S&P 500, RTY: Russell 2000, EEM: emerging markets ETF, NDX: Nasdaq 100). The underliers upon which each product's performance is dependent is fairly representative of all the products with the exception of the Eurostoxx 50 (SX5E) and the Dow Jones Industrial (INDU). Modeling those products for issuer pricings requires option data I do not have for the SX5E and does not exist on any exchanges I know of for the INDU. However, I will look at evaluating products with these underliers if there are any requests.

Next, the term column should makes sense when it's understood that y means year, m means month and the nc in the parentheses means not callable until after the given period.

Finally, the issuer column shows 8 different issuers. As in the other cases, this sample of issuers is fairly representative of the preliminary prospectuses registered with the SEC for the 1st week of March. In all, there were 12 different issuers. JP Morgan was the largest issuer by number of products with 45 out of 136.

Issuer pricing

The table below shows my estimated pricings of the issuer's valuations of these products.

The listed prices are useful in understanding how much gross profit the issuer expects to make from a given product, each of which is sold at the relative notional of 100%. When looking over these prices, the biggest thing to note is the larger range for the growth products (1-10) going from around 93% to just below 100% while the income products (12-16) range from 95% to 97.5%. This indicates there is not much the issuers can do to improve the payments of the income products while still making a profit, whereas for the lower priced growth products they could more easily enhance the return of the respective products and thus make those products more attractive investments.

The listed durations which are the price-weighted average of the payments for a given product should be compared to the listed terms for the given product in the products table. As you can see, the growth products' terms closely match the durations as the only payment is scheduled for the maturity dates.

The difference between the income products' terms and durations comes from two sources. As anyone who knows bonds can attest, one difference is due to the amount of the coupon payments relative to principal payment. The other difference is due to the structures expiring earlier than the maturity dates because of an autocall condition or issuer call option. Thus, as one can see, the products that have a call feature tend to have much shorter durations than the respective term for that product.

Historical Valuations

The chart below summarizes how the products would have performed over a past economic cycle spanning a 10-year period of start dates. The relative values have been calculated by using product-specific discount curves. The generation of those curves is based on the capital asset pricing model and as such allows the assessment of each product on a risk versus reward basis relative to simply investing in the market.

Looking at the relative values, you can see a wide variety of estimated prices ranging from 99% to 131%. Given that a value of 100% indicates a fair investment based on a risk-reward basis, the results indicate that only two products (12,13) are not fairly valued. The corresponding returns are reflective of these values with the two lowest returns being the same two products. The highest relative-value product also has the highest return but this comes at the cost of the length of the investment term which is 10 years. Interestingly enough, though, the volatility of that product's expected historical payoff is quite low resulting in a pretty good Sharpe ratio.

Scenario Valuations

The results of the scenario analyses are given below:

The calculation of these results used the historically averaged returns and volatilities of the underliers covering the same periods as the historical analyses. Also, the aforementioned product-specific discounting curves were used to discount the projected cash flows and thus arrive at a relative value for each product. Thus, these scenario results project how the products would perform on average based on the underlier performances over the past economic cycle.

Obviously it's dangerous to assume the future will exactly mimic the past. But that's not what's being done here. For each product analysis, 10,000 market simulations have been performed and the average product performance has been calculated. Thus, these scenario results indicate on average how a given product would be expected to perform should the market perform with a similar return while the underlier volatility determines how much that return can vary.

Now to the results. As you can see the relative values are generally quite a bit lower than their historical counterparts. So why would that be if the scenario analyses are using historical averages? Well, as you will see when I go over details of each product analysis in future articles, each of these products contain conditions that can lead to possible losses of the investor's principal. Over the past economic cycle, which includes the Great Recession, those conditions did not occur as often as they are projected to occur in the scenario analyses. Thus, the scenario analyses are actually more pessimistic about the possible future performance of these products than investors might assume if they just looked at the historical performance.

Still the higher valued products are well above 100% but the drops in value should serve as a warning to the possible losses inherent in investing in a given product. Of note, the returns all drop in a similar fashion except for product 12 whose very low historical return would not be expected to drop much at all in its scenario analysis.

In Conclusion

To sum up, while considering the results of the historical analyses, I would rely more on the scenario analysis results to consider whether a given product is a good investment. In that case, you can see that only 5 are well above 100%. Products 2,4,11,14 and 15 all have relative scenario values above 103%, with their historical values being even higher, which indicates good values. Of course whether a given structured product is a good investment for the needs of a given investor should really only become evident upon fully understanding the risks and rewards of each product. This understanding is achieved by not only going over the product's prospectus but also by studying a detailed analysis of the product. To help in that respect, I will provide a detailed analysis for each of the 16 listed products over the next couple of weeks.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.