Q&A: issuers are finishing the year in the cleanest way possible

As we approach the end of a tumultuous year, SRP caught up with Antoine Porcheret (pictured), equity and derivative strategist director at Citi, to discuss the role of structured products in providing much needed protection, the move to a risk-off approach from issuers, how they have shifted the risks on their books, and the increasing presence of products linked to optimised and custom indices to address to near zero-rates scenario and deliver better potential returns to investors.

After the market drawdowns in March, especially on dividends but also in the volatility and correlation, issuers are finishing the year in the cleanest way possible – the focus is on avoiding any major drawdown from market volatility.

We are seeing dealers selling volatility via long-term put options to offload their vol risk 

“From mid-September we have seen the entire sell-side willing to balance their books, offering investment opportunities to sophisticated clients such as hedge funds, pension funds and asset managers,” says Porcheret. “I think this will continue until the end of the year, even in this week’s context of optimism. Having said that, we have to be mindful that volumes for these transactions have declined in 2020, and this will be challenge in 2021.”

How are banks transferring the risk accumulated in their trading books after the disruption we saw earlier this year?

Porcheret: This is being done in many different ways from plain vanilla to complex instruments. We are seeing dealers selling volatility via long-term put options to offload their vol risk and selling dividend to hedge their long dividend risk, but we are also seeing dual-index geometric variance dispersion to address index correlation risk. In this case, the bank buys back its short exposure from clients who are willing to sell this correlation at higher-than-usual levels for carry purposes, which is a more complex way to recycle risk. 

Single stock versus index dispersion is also very much in fashion especially in the US – we have seen large Vega notional trading on US stocks versus the S&P 500. Part of this flow has been driven by primary issuance of structured products linked to US tech stocks such as Tesla, Amazon, Facebook from US and Asian investors. 

Has the risk appetite of issuers and investors changed over the last few months?

Porcheret: I don’t see any dramatic changes at all in the way products are being issued and the subsequent risk out there. If you look at SRP data, the outstanding volume on autocalls on the Eurostoxx, S&P 500, HSCEI, and Nikkei is in fact bigger than last year, simply because these products have not redeemed early and the net issuance this year has remained stable so the risk out there is even bigger.

On the other hand, unlike what we saw in March, most issuers are less hedged than they used to be. In the last few years there had been a real demand from investors for sharing banks’ vol and dividend risk, but extreme drawdowns in March meant that many of these positions performed poorly. As a result, the demand for these trades has collapsed, challenging banks’ hedging activity. If the market was to go down again the damage could be large - so this remains a concern for the market.

With rates now at rock-bottom, are there any opportunities out there to offer value to retail investors in structured products?

Porcheret: The only positive aspect I can think of in the current environment is the emergence of decrement indices. This makes sense as it can help to bring products to the market and alleviate the dividend risk. Most dealers out there are looking at decrement in one way or another. Looking at the issuance since 2015 the sales volume on the decrement indices has gone up from US$1 billion to approximately US$7bn in 2020.

I think decrement is going to become more popular – although the impact of this on the equity derivatives world will take time to unfold as issuance remains small v global outstanding notional. 

Is there a danger of over-engineering new indices and products to enhance the optics of products?

Porcheret: Decrement indices were created by banks so that the dividend risk in the equity derivatives books is significantly reduced, while aiming at not negatively impacting client returns. In a nutshell, they are based on realised dividends being reinvested into their performance (Total Return), with a synthetic dividend (in percentage or points) being then applied to end up like traditional Price Return underlyings. The pricing and the historical performance of these indices (versus the traditional benchmarks) will depend then on the level of the decrement, but usually provide more pricing efficiency and give better terms to the end client.

This kind of index is now resonating across regions and markets. This is a result of the crash in March, the unprecedented cut on dividends that made banks suffer significant losses and the subsequent lower expected yields generated by autocalls. 

Do you think the market will shy away from autocalls to avoid overexposure to this payoff?

Porcheret: Let’s not forget that long-term volatility on indices is higher, which means that the coupons you can get all things equal is bigger – so you get more money in the coupon but with interest rates at an all-time low. The trading of options on the Russell 2000 or the S&P 500 has boomed because autocalls are now as widely used in the US as in Asia or Europe where the volumes have skyrocketed. 

This week the 10Y US Treasury rates did spike to 95 bps, however when you can get a six or seven percent coupon on an S&P 500 autocall, it’s not a difficult choice. Moving away from autocalls is not easy because you are never going to get that kind of coupon, and yield, as you’re selling the full downside and you get compensated for that. You can get lower coupons and more protection with accumulator/accrual type of structures which also have a fairly attractive pricing in the current environment.

It really depends on the risk profile and what the investor wants to achieve, but at the moment there is no other structure that can beat autocalls in terms of yield. 

Why are US tech stocks and ESG taking such level of attention? Are there any other themes driving interest?

Porcheret: At the moment it all comes down to two themes: US tech stocks and ESG. Demand for US tech stocks is coming from all markets as investors want to participate on the growth story of those assets. ESG, on the other hand, is much more of a European theme but is increasingly gaining traction in the US and Asia. We are working as many other issuers on developing new products to respond to that demand. Other than those two themes we don’t see volumes going to any other particular asset.

The news around a vaccine this week has triggered a lot of optimism, with risky assets outperforming. Investors will obviously monitor developments in that space, assess what they mean for markets and whether these can start a full reversal of market moves seen this year.

Have the recent events highlighted the value of protection?

Porcheret: Protection remains key for investors and issuers. If you’re a pension fund or hedge fund manager you want to get to the end of the year with no significant losses – people are having to pay higher hedging costs to protect their positions and there is nothing you can do as the goal is to finish the year limiting any potential losses.

We cannot hide the fact that the market was given a lifeline driven by the injection of liquidity by the central banks but there is a danger of markets tanking if this liquidity stops. The question we ask ourselves this week is: “if this vaccine really is the end of Covid, does this mean that additional fiscal and monetary stimuli are a no go now and the entire Covid-QE delivered since March will reverse?”

What is your forecast for the next few months?

Porcheret: The question mark structurally is when this will stop and what will force central banks to review their monetary stimulus policies. If we have a scenario of markets going down by 30% and inflation going up to six percent, then those policies might be reviewed because debt and deficit would also be in the picture. 

We don’t think 2021 will be much different from what we have seen over the last few months. The injection of liquidity has suppressed risk premia and volatility, but structured products remain a valid option to play different market scenarios. Demand from retail and private banking clients remains strong, and they represent a fair amount of wealth across markets and regions. As long as they have liquidity to invest these products will become more popular. 

The liquidity injected by central banks goes to what we call ‘first receivers’ which are usually the asset owners already invested in real state, the bond market and alternative products such as structured. As long as the money continues to flow for top down structured products will remain popular because they can deliver better value than bonds - the increase in issuance in the US is connected to how little you can get in the bond market with the US 10-year rates are at 95 bps - you can get almost 10 times that with an autocall structure.