March Structure No. 16 -- Pardon My French, A Cliquet That's Okay

by: Reid Guenther


Detailed analysis of structure No. 16 from the March structured products survey.

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

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

This is the only note in my March survey that has a cliquet (klee-kay) or ratchet coupon feature. Though it sounds exotic, it's really not -- as it simply means that each coupon payment depends on the performance of the underlier between the ends of the current and previous coupon periods. As you will see in this analysis, this feature is beneficial to the price of the structure as it helps decouple the final return of investor principal with the periodic coupon payments. This allows the structure to be an okay investment.

The Structure

The following table contains the basic information about the product:

This income product is partially principal-protected ("PPP"). The principal protection is in the form of a 15% buffer, which puts a floor on the potential loss of the investor's principal. To reiterate the intro, the cliquet is a ratchet-like feature where the level of successive coupon payments depends on how the underlier performs at the end of the current coupon period relative to its level at the end of the previous period. Those coupons are paid annually and their level (2.5% or 5.0%) depends on the performance of the S&P 500 (SPX). The term of the structure is 5 years.

Here is the cliquet coupon logic:

So if the underlier return from the end of one coupon period to another is 0% or greater, then a 5% coupon is paid for the given period. Otherwise, a 2.5% coupon is paid for that period. As you might expect, the first coupon payment depends on the underlier return between the end of the 1st period and the closing price on the trade date.

Here is the final payoff logic:

If the underlier return on the valuation date relative to the trade date is -15% or greater, the investor's principal is returned. If that return is less than -15%, then the issuer returns a portion of the investor's initial principal, which declines at the same rate as the underlier but includes a 15% buffer. The use of this buffer means that the maximum possible loss of principal is -85%.

Here is a graphical representation of that final principal payment:

Of course, all these payments assume the issuer does not default. Information about the issuer's debt obligations along with more specific product details can be found using the SEC's EDGAR search engine by looking up the product's CUSIP, 48128GQU7.

So now let's take a quick look at the valuations which were computed as of the analysis date, 03/11/2016:

As you can see, the estimated issuer price of 95.02% leaves some room for improving the product terms while still allowing the issuer to expect to hedge a profit over the term of the structure. Given the historical valuation of 108.12%, you would conclude that adjustments are not necessary. But the scenario valuation of 101.30%, even though above par, could use a boost if the issuer would improve the terms of the structure. Also, the historical average coupon payment of 4.43% is close to the maximum of 5%. But the scenario average coupon is a bit lower at 3.85%. This also indicates that the issuer needs to improve the structure terms to make this a better investment.

The Analysis

This graph shows how structure No. 16 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 S&P 500 is given to show how its performance relates to the historical discounted payoffs.
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Those payoffs have been discounted using a structure zero curve that was generated using the capital asset pricing model. This allows the computed relative values 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 S&P 500.

Now regarding the above graph, the first thing to note is that only in a few instances does the investor lose their principal. This occurs in 2003 -- about 5 years before the financial crisis. For the rest of the cases, what you are seeing is the digital levels of coupon payments of 2.5% and 5.0% being made. The highest level occurs when all 5 coupon payments were at the 5% level, the next level is for 4 out of 5 were at 5%, and so on.

This graph of the average undiscounted coupon payment made as a function of the historical analysis date should help to clarify the historical number of maximum coupon payments relative to underlier behavior.
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Again the top level, which shows an average payment of 5%, corresponds to when all 5 coupon payments were paid 5%. The next level is for 4 out of 5, followed by 3, with the lowest being 2 out of 5 times the max 5% coupon payment being made.

This last case only occurred once and happens around the market peak before the financial collapse of 2008. It indicates that in 3 out of the 5 following years from the given historical date, there was a year-to-year negative underlier return. For the given 10-year historical period, this is quite rare. For the majority of historical cases, 4 or 5 out of 5 max coupons were paid. Those cases happen during long bull runs of the underlier.

So now let's look at the historical distribution of discounted structure values:
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As expected, the vast majority (97.5%) of the distribution is above par. Given that the peak is centered just below 110%, with about 10% more of the distribution below than above the peak, the historical valuation of 108.12% makes sense.

Finally, let's take a look at the corresponding scenario distribution:
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For this 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.

As you can see, while the majority of the distribution (77%) is above par, a much larger percentage compared to the historical distribution is below, extending all the way down below 50%. Thus, the scenario simulation reminds us that the past should not be relied upon to predict the future, and so large losses of principal are possible. Given the increased possibility of these large losses in the scenario simulations, its valuation drops by 7% to 101.30%.

In Conclusion

The above par valuations indicate that this is a good investment. However, the large drop between the historical and scenario simulations makes me hesitate in making that statement. And so let's just conclude with by saying this is expected to be a reasonable investment, but that there are better structured note investments out there. Some of those better investments should be found in my forthcoming April survey.

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.