UBS’ autocalls on indexes, ETF use sector play, dispersion to boost coupon

By Emma Trincal

New York, Nov. 1 – UBS AG, London Branch’s upcoming trigger autocallable contingent yield notes due Nov. 8, 2027 linked to the least performing of the S&P 500 index, the Russell 2000 index and the Utilities Select Sector SPDR fund provide better terms than the typical index-linked worst-of autocall through the use of a sector ETF, which generates additional premium, sources said.

The notes will pay a monthly coupon at the rate of 11.4% per year if each underlier closes at or above its coupon barrier, 70% of its initial level, on any related observation date, according to a 424B2 filing with the Securities and Exchange Commission.

After three months, the notes will be automatically called at par plus the coupon if each underlier closes at or above its initial level on any monthly call observation date.

If the notes are not called and the final level of each underlier is greater than or equal to the downside threshold level, 60% of the initial level, the payout at maturity will be par plus any final coupon.

Otherwise, investors will lose 1% for every 1% that the worst performer declines from its initial level.

Correlations

“The terms look good although you always have to run the numbers first,” said an industry source.

Data compiled by Prospect News for the past month showed that worst-of index-linked callable notes with contingent coupons at or in excess of 11.4% per year were either built as issuer calls (as opposed to autocalls) or had incorporated the more volatile Nasdaq-100 index as one of the three underlying indexes.

“I think what drives the pricing here is the low correlation between the utilities ETF and the two indices,” he said.

“ETFs are mini-indices. They’re not as diversified as a broad equity benchmark.”

The Utilities Select Sector SPDR ETF has 30 components.

“This utilities fund is not highly correlated to the S&P and the Russell,” he said.

The four-year coefficient of correlation between the utilities fund and the S&P 500 index is 0.48. The ETF’s correlation with the Russell 2000 is 0.36. On the other hand, the two broad indices have a higher coefficient of 0.88.

Volatility, dividends

Volatility was another factor adding premium since the income-oriented structure is short volatility.

The most volatile underlier is the Russell 2000 with an implied volatility of 26.63%. The Utilities Select Sector SPDR ETF follows closely with an implied volatility of 25.18%. The S&P 500 index’s volatility is 18.73%.

Another factor behind the compelling pricing was the ETF’s high dividend yield of 3.61%. Such yield is nearly 2% above that of the S&P 500 index.

“The higher the yield, the more pricing power you get for the options,” he said.

A less important factor was the short period of call protection, a meager three-month no-call period, he noted.

This period could have been longer. Its short duration also helps generating more premium as it increases the call risk.

“You can get called in three month. Your guaranteed minimum contingent coupon is going to be very small,” he said.

Those factors helped explain how the notes were priced, he said.

“Everything adds up. Dispersion, volatility, high dividend, three-month no-call. You don’t know what’s the biggest driver until you price it. But I would be tempted to think that the low correlation is a big one,” he said.

Deep protection

A buysider pointed to the use of the ETF in the worst-of as the source of extra premium.

“That 60% barrier is pretty deep,” he said.

“With that type of barrier and if you did this note on three common indices, your coupon would be in the 9% range, not 11.5%.”

This buysider also saw in the high dividend yield a source of premium.

Dispersion risk was a key factor as well.

“As a buyer, you’re long correlation. You hope the assets will become more correlated.

“The issuer on the other hand is short correlation. They’re betting that correlations will fall out of bed,” he said.

Sector ETFs

This buysider noticed the increased use of the Utilities Select Sector SPDR ETF in recent autocallable notes with worst-of payouts.

“We do something very similar. Instead of using three equity indices, we do two plus a sector ETF. Just like this one,” he said.

This buysider has been using the Energy Select Sector SPDR ETF rather than the Utilities fund.

“It’s the same idea. You introduce a defensive sector with a high dividend yield,” he said.

Strategic, value plays

Despite its high valuation, the energy sector is relatively “defensive,” he said.

“There is this government bid to refill the Strategic [Petroleum] Reserve that’s very depleted,” he said.

Geopolitical factors are also at play with the current war in the Middle East, which may disrupt global oil supplies if the conflict was to expand in the region.

Utilities are more of a value play but are not without risks, he noted.

“Utilities suffer from the rising interest rates. This fund has been beaten up. Now, it offers some value.”

The ETF price is trading 18% below its high of December.

“I do like putting those sector ETFs in a worst-of. You keep two indices but add something a bit more esoteric to get some juice. We do show those notes to our more sophisticated clients,” he said.

UBS Securities LLC and UBS Investment Bank are the agents.

The notes will price on Nov. 3 and settle on Nov. 8.

The Cusip number is 90279WPB4.

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