Autocallable notes gaining new fans

As equity markets trade lower amid inflation fears and rising commodities prices, some pension funds are turning to autocallable notes — structured investments that offer a high fixed rate of return and downside equity market protection.

However, experts say the notes offer limited upside potential and expose buyers to counterparty risk of financial companies whose stocks have been battered lately.

“Pension funds are facing a real challenge to meet their high rate of return targets, so we are working with them to meet their benchmarks,” said Michael Heraty, director in equity derivatives at Merrill Lynch & Co. Inc., New York, and co-architect of the firm's enhanced liquidity note. “Derivatives, including this one, are a must-have tool to gain more efficient access to a higher rate of return.”

Autocallable notes are medium term, non-principal protected notes that can be linked to the performance of an underlying stock, basket of stocks or equity index. The notes provide investors with the potential for a high yield at maturity. The automatic call feature will be triggered if the share price of the underlying investment is at or above the initial strike price three days prior to any of the call dates or at the date the contract expires.

For example, a note would offer a guaranteed return of, say, 12.5% as long as the S&P 500 returns between a certain range. If the note is redeemed early, the investor would receive his principal plus 12.5%. Maturities range from three to 10 years, but so far public funds largely have purchased notes with a five-year maturity, Mr. Heraty said. He declined to identify the funds.

However, the investor bears the investment risk where the underlying basket of stocks or equity index falls by 50% or more from its initial level. In that case, the investor receives the price performance of the underlying index at expiration.

Cynthia Steer, managing director and head of research at Rogerscasey LLC in Darien, Conn., said autocallables are highly structured and a form of insurance to the holder.

“The attraction is it (the autocallable) balances a pension fund's risk in its portfolio. In a portfolio that seeks to balance the upside and the downside, it has a place as part of an overall allocation,” Ms. Steer said. “I think it is early, but by the end of this quarter, the carnage in the stock market will put protection on the agenda” making autocallables a good investment.

These types of notes are not new, said Diane Garnick, investment strategist at Invesco Ltd. in New York.

Morgan Stanley Investment Management spokeswoman Erica Platt said MSIM issues autocallable securities, but declined to comment further. Michael DuVally, spokesman for Goldman Sachs & Co., declined to comment.

“Typically, a pension plan sponsor would buy this if they have a neutral or negative market outlook,” Ms. Garnick said. “When brokers package these instruments on behalf of pension plans, counterparty risk becomes important. In this case the pension fund has to believe in the creditworthiness of the underwriter.”

When buying an enhanced yield note, plan sponsors assume counterparty risk with the issuer. For example, should the firm enter into financial duress, the autocallable could limit the firm's ability to provide the advertised rate of return. If the firm becomes cash poor it may not be able to meet its obligations, such as its underwriting obligation to provide the rate of return to the buyer of the autocallable.

The plan sponsor who buys the note also forgoes higher returns should the underlying index move higher than the strike price on the call and the note is called by the issuer.

Yonathan Epelbaum, managing director in charge of equity solutions for pension plans and co-architect of the enhanced liquidity note, at Merrill Lynch acknowledged the upside is limited for the investor. If the underlying index rises higher than what the note states, investors will not realize the additional gain. However, the allure of the notes is the limited losses a plan sponsor will sustain during a prolonged drop in U.S. equity prices, as is now happening.

“If the underlying index never falls to 50%, you can never be worse off (than if you had invested in an S&P fund).” The worst-case scenario was that a plan sponsor would get back its initial investment but lose the time value of money committed to the note.

And it was that single reason that makes these securities popular among public plan sponsors. Mr. Heraty said plans achieving their targeted rate of return, historically between 8% to 8.5%, was the most overriding concern for buyers of the enhanced liquidity notes and the buyers were willing to forgo the potential future returns a rallying U.S. equity market might provide.

Ms. Garnick said smaller endowments that do not have large staffs and personnel also would be likely candidates for these structured notes.

Ms. Steer said she knows that public and private plan sponsors are buyers of these as are wealthy retail investors. However, she said the fee structures in creating the notes are very expensive.

Contact John D'Antona at [email protected]

Updated with clarification