Comment: Autocallables: High coupon rates also mean high risks

This article first appeared in Wealth, The Edge Malaysia Weekly, on March 29, 2021 - April 04, 2021.
Comment: Autocallables: High coupon rates also mean high risks
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A fallout from the low interest rate regime is that investors may be tempted to take on more risks to chase higher returns. It is well and good for those with lots of cash to spare but, for the man in the street, it is better to be more aware. 

At 1.75%, Malaysia’s Overnight Policy Rate (OPR) is at its lowest in more than two decades. Fixed deposit (FD) rates, in tandem, have been trending below 2% in sync with the benchmark rate.

To chase higher returns, many investors have started to look at alternative options beyond the traditional safe haven, FD rates. Even retirees, many of whom are considered to be very conservative with their money, have also begun to cast their net wider and further afield, daring to take more risks. 

An asset class that has gained traction in the last couple of years on local shores is structured products, which often offer high coupon rates but the higher returns often come with higher risks. The underlying asset for a structured note can be anything, such as an equity, an index or a currency.

Many of these products are being pitched to priority banking customers looking for higher returns. The problem is that many investors do not understand these complicated structured products and, in some cases, neither do the salespeople who promote these products to their clients.

History has shown the high-risk nature of structured products, which are derivatives. Remember the collapse of Lehman Brothers during the 2008 global financial crisis? Many investors bought Lehman Brothers structured notes just before the collapse of the US financial markets. The notes were 100% principal guaranteed, thus enticing many retirees and conservative investors into thinking they were safe to put their money in. 

What many probably did not know at the time was that the guarantee was good as long as Lehman Brothers stayed in the business. But, who would have expected the company, which dated back to 1850, would collapse and face financial carnage in 2008? Investors ended up with almost nothing.

In the Malaysian market, amid the prolonged low interest rate regime, one structured product that has gained some ground and been issued by several financial institutions is autocallables, of which the underlying asset is usually an equity and often with a maturity period of 12 months. 

Last year alone saw a slew of these structured notes being issued, with underlying stocks such as Genting Bhd, Public Bank Bhd, Guan Chong Bhd and Serba Dinamik Holdings Bhd. The coupon rates ranged from 6% to 11%, which would have appeared to be very attractive compared with FD rates of around 2%. 

And therein lies the danger. Many investors would have been tempted to jump in without a clear understanding of the risks involved.

What are autocallables? They are option-linked derivative structures that often pay a high coupon rate. If the underlying asset (for example, equity) passes an upside barrier (knock-out level), it automatically matures (without reaching the end of maturity) and the investor gets back the principal sum plus interest.

Investors do not enjoy any upside to the stock beyond the coupon payment. Issuers, on the other hand, will be able to roll out new structured notes to attract investors that have cashed out. 

Therein lies the crunch: When the stock price falls and the knock-in price is breached, investors may eventually end up with the shares at a higher price instead of being paid the principal sum.

The knock-in price can vary; in most cases, it is set at between 70% and 85% of the strike price. Investors will be paid interest before the last observation date of the autocallable but, once that date is reached, investors get interest plus shares at the strike price set at the beginning of the tenure. In many cases, the risk is that the interest payments do not offset the loss from the tanking of the share price of the underlying stock.

Let us assume an autocallable’s underlying stock is X, the maturity period is 12 months and the observation date is monthly. The knock-out price is 105%, knock-in price is 80% and strike price is RM10. Once the share price of X breaches RM10.50, the knock-out price is triggered. Investors get back interest plus their principal.

If the share price of X hits RM8 (80%) before the last observation date, investors will receive the accrued coupon and the trade continues until the last observation date. If X falls to, say, RM7, the investor gets shares (at a strike price of RM10) plus interest. They do not get back the principal sum in cash. Unless the share price of X recovers and claws back lost ground to above RM10, investors may end up with a loss. Noticeably, the investors bear all the risks and the issuers bear none. 

Autocallables are good if the share price of the underlying stock performs within a narrow range during its tenure. Only then will investors benefit from the high coupon rates.

But if the market is bearish and the one-year outlook is uncertain, it is better to stay away. The high coupon rate is not given without a reason — it implies high volatility and high risks. The upside is limited but the downside, unlimited. Many investors may be under the perception that the risk of an autocallable is related to the strength of the underlying stock and how well managed it is. In reality, it has more to do with market sentiment.

As the adage goes — higher returns always mean higher risks. If one must invest in these complex instruments, be prepared for the risks that come with it and have the spare cash to lose. It is definitely not for retirees who cannot afford to lose their nest egg. If a 150-year-old institution such as Lehman Brothers can collapse during a financial crisis, worse can happen anywhere, anytime.