March Structure No. 12 -- A Callable Note But Not A Good Call

by: Reid Guenther


Detailed analysis of structure No. 12 from the March structured products survey.

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

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

This is the first purely income generating structured product in my
March survey. Income structured notes with equity underliers tend to be callable either automatically due to underlier performance or at the discretion of the issuer. This feature allows the issuer to pay a higher coupon. As you will see in my next few articles, whether the callable feature is good or bad for the investor is very much dependent on the individual features of the product. As the analysis will show, this callable note turns out to be a bad investment. Before delving into that, let's review the details of this structure.

The Structure

The following table contains the basic information about the product:

This income product is not principal-protected ("NPP"). It pays a monthly coupon (7.25% annual rate) and is callable by the issuer at quarterly intervals. The final return of principal of the structure depends on the minimum performance between two underliers, the Russell 2000 (RTY) and the S&P 500 (NYSEARCA:SPY). The maximum term of the structure is 1 year with the (nc 3m) indicating that the structure is not callable for the first 3 months. And thus, at least 3 months of coupon payments will be made.

If the issuer decides to call the structure, they will repay the investor's initial investment and pay the coupon due for that month with no more payments made afterwards. If the structure is never called, then the final amount of principal paid back is dependent upon the underlier performance. That final principal payoff is detailed in the following logic table:

If the structure is not called early, the final payoff depends on the performance of the daily closing prices of both underliers from the initial trade date to the final valuation date. If one of those prices for either of the underliers falls below 75% of its respective value on the initial trade date, then final principal payment will be the minimum of the underlier returns on the valuation date if that underlier return is below 0%. Otherwise the investor's initial principal will be returned in full.

Admittedly that's a bit of a mess of a payoff condition, but not
unusual. You might need to read that a few times for it to sink in if
you have not encountered these types of conditions before. Suffice it to say, for this structure, how the underliers perform on a daily basis will determine the final principal payment. Again, this is if the
structure is not called early. So you see, having the structure called
early can actually be beneficial for the investor as they will receive
back their initial investment.

Of course, all these payments 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, 06741U5Y6.

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

The issuer pricing shows that they do have room to improve the terms of the structure and still expect to hedge a profit, especially as they will only be hedging the structure for no more than a year. The historical valuation is the worst of all 16 products in the March survey. The forward-looking scenario valuation is one of the worst too. The reason for these low valuations will be discussed in the next section.

The Analysis

This graph shows how structure No. 12 would have performed over a past period covering 10 years of start dates and thus encompassing a full economic cycle. The same structure but without issuer callability is shown for comparison. 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.

Those total payments include the cumulative coupon payments. Thus, as you would expect for the non-callable case, the discounted total payment will be higher than its counterpart when an early call occurs and the investor's initial principal is returned. Those cases are the horizontal line of blue points above 100. The early calls are the green points that are different from their non-callable counterparts. Except for two cases, the value of the early calls are all below the non-calls. As you might expect, the issuer will tend to call the structure as the underlier increases from its initial value.

When the underliers drop in value, as they do in the year before the financial crisis, the structure tends not to be called early, and thus the callable and non-callable points coincide. In this case a loss of principal occurs. The two cases when this does not happen are when the underliers initially rose high enough that the issuer calls them early. The subsequent drop in value results in the non-callable case actually losing value. In those cases the call feature prevented the investor from losing his principal.

This next graph shows the cumulative undiscounted amount of coupons paid for the callable and non-callable cases along with relative underlier performances. The digital levels of the callable payments indicate when the structure was called -- the lowest level being at the end of the first quarter and the highest being when the structure was not called early.

As you can see, the structure was mostly called at the end of the 1st quarter and the second mostly was at the end of the second quarter followed by the structure not being called (4th quarter).

So now let's take a look at the cumulative distribution of callable and non-callable payoffs:

As the legend indicates, 86.8% of the non-callables are above par. These are the cases when all coupon payments were made and the investor's principal returned. The 88.4% above par for the callables is higher because of the two cases where the structure was called early when the non-callable subsequently lost part of its initial principal. For the points below par, the callable and non-callable distributions match up except for the two lowest non-callable bars around 60. Even though such a large amount of points are above par, the discounted value is only slightly above par. Having the remaining points spread out well below par results in the callable historical valuation being below par.

Now lets look at the distribution of combined scenario payments for both the callable and non-callable case.

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.

As you can see, the scenario distributions are very similar to their historical counterparts though the larger sample size of the scenario simulations generates a smoother distribution of below par points. As such, the scenario valuation is similar to the historical at 97.77%.

In Conclusion

Given that both the historical and scenario valuations are well below par, it is easy to conclude that this is a bad structure. From my experience in analyzing products with call features, I would say the biggest reason why this callable structure is a bad investment is the relatively short term of the structure. That short term means that the level which causes the final principal payment to experience losses is fairly high at 75%. This level is especially high considering that it is for all the closing prices during the life of the structure. As you will see for the next callable structure which also has a 1 year term, it is a bad investment too. But the callable structures after the next all have longer terms and turn out to have good expected values.

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.