March Structure No. 11 - A Growth And Income Note: Double Return Or Double Trouble?

by: Reid Guenther


Detailed analysis of structure No. 11 from the March structured products survey.

Results detail why this is expected to be a very good investment.

But the structure design combined with the long term means the overall payoff will be either feast or famine.

Link at the end provides a data file for use in helping you evaluate similar products.

After 10 growth structured products, these analyses of products in the March survey turn towards income generating structures. The first is an apparently rare type which attempts to deliver both growth and income. The analysis shows that the success of those objectives are not independent for this product. As such, this article should prove indispensable in helping you understand the risks and rewards of structure No. 11 and why it is expected to be a good investment.

The Structure

The following table contains the basic information about the product:

This is a growth and income product that combines the possible growth of principal with contingent coupon payments. Of note, this structure was the only product out of the 164 registered with the SEC in the first week of March that combined both growth and income. The principal is not protected ("NPP"), coupons are paid quarterly over a 10-year term and the amount of the coupon payments and final principal payment are dependent on the minimum returns of the Russell 2000 (RTY) and the S&P 500 (SPX).

The following table gives the logic for the final principal payment:

If the minimum underlier return at the valuation date relative to the trade date is at or greater than 0%, then the investor receives 175% of his initial investment. If that minimum return is less than 0% but greater than or equal to -50%, then 100% is returned. Below a -50% minimum return results in a loss of principal equal to the minimum underlier return.

This chart visualizes the final principal payment logic:

Now, for the coupons, this table details the conditions necessary for
making a quarterly payment:

If the minimum underlier return at the end of a given quarter relative to the initial trade date is at or above -35%, then a 1.25% coupon is paid (5% annualized rate). If below -35%, then no coupon is paid for that quarter. All these payoffs assume the issuer does not default. Information about the issuer's debt obligation and more specific product details can be found using the SEC's EDGAR search engine by looking up the product's CUSIP, 61761J2E8.

Finally, here are the valuation results for this structure which were computed as of the analysis date, 03/11/2016:

The issuer pricing shows that they do not have much room to improve the terms of the structure and still expect to hedge a profit especially as they will have to do it over 10 years. The historical valuation is quite high and actually the highest in the March survey. The forward-looking scenario valuation is also good and again the highest in the March survey. The reason for these high valuations and how much is due to the digital return and how much is due to the contingent coupons is explored in the next section.

The Analysis

This graph shows how structure No. 11 would have performed over a past period covering 10 years of start dates and thus encompassing a full economic cycle. Also, the relative performance of the Russell 2000 and the S&P 500 is given to show how their performance relates to the historical discounted payoffs.

Those payoffs have been discounted using a structure zero curve that was generated using the capital asset pricing model. This allows the computed relative value to be a measure of the risk versus reward of investing in the structured product as opposed to investing in the underlying market, which in this case is the Russell 2000.

The annually compounded structure discount rate on the product maturity date is computed to be 5.57%. Thus, the 175% relative payment has a discounted relative value of 101.78%, while the 100% return of investor principal payment has a discounted value of 58.16%. The occurrence of these two payments can be picked out in the previous graph as the topmost set of points and the 44% and over drop in value.

That drop in value occurs as the S&P 500 peaked in the late 1990s into the early 2000s. The S&P's inability recoup its value 10 years later results in return of principal payments being made. During the drop in value of the structure, the level varies from slightly below 100% to just above 90%. These variations are due to the number of contingent coupon payments being made.

Regarding those coupon payments, as you can see the discounted value for when all 40 contingent coupon payments are made is about 40%, with those complete set of coupon payments being the topmost points in the graph at a discounted cumulative value of around 142%. Thus, the slight deviations from the topmost points show the cases when the coupon payments are not paid for a number of periods over the lifetime of the structure.

To better understand when and how many coupon payments are missed, the following historical graph shows just the value of the undiscounted coupon payments as a function of each historical analysis date. Thus, the relative value of 50% is when all of the 40 1.25% coupon payments are made. As you can see, those cases even extend into the initial part of the drop-off of the discounted total payments shown in the previous graph. But coupon losses continue to occur after the digital return payment of 175% resumes being paid.

More importantly to note is the digital drops in the coupon payments. Each level below the top indicates the number of missed coupon payments. Thus, for the majority of cases, 0 or 1 missed coupon payments occurred. The big drop in the number coupon payments occurs during the aforementioned market peak that corresponds to the drop in the final principal payment -- the max number of missed payments occurring being 7 with no more than 2 missed coupon payments occurring when the final digital return payment was also made.

Now in order to understand the historical valuation, here is the distribution of the combined discounted principal and coupon payments. 76.9% of those relative payments are around 140% while the remaining 23.1% lie between 90 and 100%. Thus the computed value of 131.06% lies fairly close to the maximum possible value of about 142%.

Now let's look at the distribution of combined scenario payments.

For the scenario analysis, 10,000 simulations were performed. They used the same structure discount zero curve as well as the historical average return and variance of the underliers over the same period as the historical analysis.

The scenario total discounted payment distribution graph shows the three principal payment regimes described in the payoff logic table. The 175% principal payment and 100% principal payment regions correspond to the two peaks with the tapering levels to their left due to loss-of-coupon payments. This is better understood when you compare this graph to the historical distribution. Thus, the scenario simulation predicts a larger number of missed coupon payments.

The third region is centered around a cumulative discounted payment of 40%, which is broadly distributed above 60% to below 20%. As you might expect, this broad distribution shows that not only are the principal payment losses substantial, but that the loss-of-coupon payments are as well.

Still 52.3% of the scenario simulations result in the digital return payment being made and the approximately 15% of return-of-principal payments with most all of the coupon payments being made lead to the scenario valuation being well over par value at 109.95%, which is definitely a good value.

Now, before concluding, I just wanted to make a quick note about the expected value of the coupons being made over the life of the structure shown in this graph:

What the graph shows is the expected coupon payment drops steadily over the life of the structure from the maximum amount of 1.25% down to 0.95%. Thus, the probability of missing coupon payments increases over the lifetime of the structure. This should serve as a warning of the risk of investing in very long-term structures.

In Conclusion

With both the historical and scenario valuations being well above par, this structure has a very good expected value. However, the historical analysis showed that the number of contingent coupon payments and the final principal payment of the structure are highly correlated. This results in a feast or famine scenario in terms of how much this structure pays out and should also serve as a warning to investors about the risk of investing in this longer-term product.

To further assist with understanding this analysis and to help you analyze similar products, here is the historical data and payoff logic used in the historical portion of this analysis.

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.