UBS’ contingent income autocallables tied to ETFs use worst of, volatility to price 15% yield

By Emma Trincal

New York, Dec. 6 – UBS AG London Branch’s contingent income autocallable securities due Dec. 9, 2022 linked to the lesser performing of the SPDR S&P Biotech exchange-traded fund and the SPDR S&P Oil & Gas Exploration & Production exchange-traded fund pay a double-digit coupon, but with that comes an enhanced risk of the notes not getting called and principal loss at maturity, said Suzi Hampson, head of research at Future Value Consultants.

Each quarter, the notes will pay a contingent coupon at the rate of 15% per year if each ETF closes at or above its trigger level, 65% of its initial share price, on the determination date for that quarter, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be automatically called at par if each ETF closes at or above its initial share price on any quarterly determination date other than the final one.

The payout at maturity will be par unless either ETF finishes below its trigger level, 65% of its initial share price, in which case investors will lose 1% for every 1% that the lesser-performing ETF declines.

Risk versus reward

The high coupon of this product comes from correlations.

“You’re trying to extract premium when using two different underlying that may or may not move in synch, said Hampson.

At 0.75, the coefficient of correlation, however, is “not too bad,” she said.

“When correlation is very low or negative, it’s more risk to the client as the chances of breaching the barrier increase,” she said.

“A very low correlation is a warning suggesting higher risk.

“Here, it’s not exactly that way. The correlation is not bad. We’re dealing with stocks from the S&P 500.

“The fact that they’re in different sectors, oil and biotech, is not causing a huge discrepancy.”

In order to generate the 15% coupon, the issuer had to tap into the implied volatility of both underlying funds as well.

The implied volatility is 26% for the SPDR S&P Biotech ETF and 31.6% for the SPDR S&P Oil & Gas Exploration & Production ETF.

“It’s quite high, especially for the oil equity fund, when compared to the S&P 500 index itself, which is at around 16%.

“It’s by adding the volatility factor to the worst of that the issuer was able to price the high coupon.”

Defense

The barrier level for the principal repayment at maturity had to be examined in light of the risk.

“A 65% European barrier sounds good. As long as none of the two underlying drops more than 35%, you get your money back at maturity,” she said.

A barrier is European when the observation is point-to-point.

“But a 15% coupon immediately suggests you’re going to get some risk, so you would expect this deep barrier. It is nothing but a reflection of the relatively higher risk.”

While the correlation is “not bad,” both funds are individually volatile, and the payout is linked to the worst of the two.

“That’s where the high coupon comes from.”

Product-specific tests

Future Value Consultants generates stress testing on structured notes, which is designed to determine the probabilities of occurrence of outcomes pertaining to a specific product type.

The firm’s simulation model uses market and implied data to run the tests, including risk-free rate, issuer credit spread, deposit rate, dividend yield and volatility as well as correlation matrix.

She picked the “product-specific tests,” one of the 29 tests or “tables” included in each report. The table displays probabilities of outcomes pertaining to the structure.

In this case, the various outcomes include probability of barrier breach, probabilities of an autocall at various dates and probabilities of coupon paid at various times.

First call

The table showed a 38.64% probability of a call at point one, which is at the end of the first quarter.

“This probability is characteristic of worst-of autocalls. If you had the same product but tied to a single asset, you would probably see a probability of 50%. But with the worst of, both have to be above initial price, which lowers the probability of calling to 39%,” she said.

“This is a big change compared to deals tied to a single underlying.”

Missing calls

The payoff increases the odds of not seeing the notes called on the first call date.

“The other side of the coin is that you may earn the coupon a little bit longer,” she said.

But it also adds some risk.

“Every call point that you miss increases the chances of breaching the barrier at maturity.”

As with any other autocall, after the first observation, the probabilities of a call will drop progressively. The call at point 2 has a 12.76% chance of happening, falling to 5.95% at point 3 and 3.81% at point 4. After that, the probabilities decline from 3% on the fifth call date to 0.69% on the 12th one.

The chances of no call at all are relatively high. The table showed for this outcome a probability of 27.43%.

“The probabilities of no call are higher. The chances of a call at point 1 are lower. When you compare a worst of like this one with an autocall on a single asset, that’s what you’re going to get,” she said.

“The pattern of decline over time is the same. It’s not like you’re spreading the chances of a call more evenly after the first call date.”

As a result, the likelihood of a barrier breach is also higher. The table points to a 20.78% probability associated with this outcome.

Coupon used as buffer

“It’s quite high, and it shows that you’re better off calling at some point and sooner than later. It would be risky to buy the notes in the hope of collecting as much coupon payments as possible,” she said.

One redeeming factor in the event of a barrier breach is the earned income, which is likely to offset some of the losses.

“Since you can get paid even if you don’t kick out, as long as the worst of is anywhere between 65% and below 100%, you could still collect several coupon payments until maturity,” she said.

A barrier breach at maturity means in theory at least 35% in principal loss. But the coupon payments can help, she explained.

Assuming the worst of breaches the barrier declining by 35.01% and assuming the coupon is paid six times, the 22.5% return accumulated in income would reduce the loss to 12.51% when the notes mature.

Phoenix versus snowball

“This is where the autocallable contingent coupon phoenix type can help mitigate your losses compared to a snowball,” she said.

Snowballs are autocallable products that only pay upon the call, usually at a trigger set at the initial price. Unlike the so-called phoenix products, which offer a coupon barrier at a lower strike than the 100 call trigger, snowballs do not provide for income when the product is still live.

“A snowball will pay more in call premium because the barrier for the call is higher at 100. There’s more risk involved. Not only is the threshold higher but you don’t build any income stream,” she explained.

While snowballs pay unpaid prior premiums upon a call (memory feature), if the call fails to occur, investors have no buffer to rely on.

“With a snowball, if you never call and breach the barrier at maturity, you have nothing that will allow you to offset your losses,” she said.

Thirst for yield

In conclusion, she said the notes were designed for aggressive income investors.

“It’s an appealing product on the basis of its return. It pays 15% per year. That’s what’s going to attract investors,” she said.

“At least you still have a reasonable chance of getting your first couple of coupons.

“If the notes don’t kick out, however, you also have a reasonable chance of capital loss.

“Any product delivering a potential return of 15% a year will have to come with risk.

“The only way you can obtain that type of return from an autocall is to either use a highly volatile single stock or use a combination of correlation and volatility in a worst of. They chose the latter.

“You’re getting paid a high rate mainly through the worst of. That’s the kind of trade-off you may expect.”

UBS Securities LLC is the agent. Morgan Stanley Wealth Management is dealer.

The notes will settle on Dec. 11.

The Cusip number is 90281F511.

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