Wells Fargo’s contingent market-linked autocalls on biotech fund offer aggressive income play

By Emma Trincal

New York, May 23 – Wells Fargo & Co. plans to price market-linked securities due May 29, 2020 – autocallable with contingent coupon and contingent downside linked to the SPDR S&P Biotech ETF, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will pay a contingent quarterly coupon at an annual rate of 8.5% to 9.5% if the fund closes at or above its 75% coupon threshold on the observation date for that quarter.

The notes will be called at par if the fund closes at or above its initial level on any quarterly observation date after six months.

The payout at maturity will be par unless the fund finishes below its 75% downside threshold, in which case the payout will be par plus the return with full exposure to any losses.

Perception vs reality

“This is not a bad deal. It’s just a little bit more aggressive than we like,” a market participant said.

“9% is a high coupon to be pursuing for these structures.

“I usually like to do this with a slightly lower coupon and more downside protection.”

His rationale was based on the need to manage clients’ expectations.

“Those income products tend to be less risky than growth products. They have more protection and you get limited upside so they look a lot more like bonds.

“It can be problematic. There is among investors the perception that these notes are a substitute for fixed-income. Well it’s not really true.

“I’m not saying you shouldn’t use it for the coupon. But those who use it should understand that it’s not a bond. You can still lose your principal.

“As long as you understand your risk, you’re fine,” he said.

Conservative approach

One way to solve this issue is to look for lower barriers, he added.

“I won’t do anything less than 60%,” he said about the barrier at maturity, which will determine the amount of principal repayment.

“In fact, 50% is even better.”

This conservative approach is designed to incorporate what he calls “mixed assets,” in a portfolio allocation.

This market participant qualifies contingent coupon notes are mixed assets. That’s because the structure has equity characteristics due to its underlying while the return is fixed.

“You are at risk and you don’t get any participation in the upside,” he said.

Mixed assets

As a result of their “mixed” nature, this market participant uses the delta of the underliers of these income notes as a tool for his overall asset allocation.

“When I look at income structures I always want to see lower barriers and lower delta,” he said.

“If I want to be conservative I would put the delta at 0.5. That way, I can assign a 50/50 equity-fixed-income allocation.”

The delta of an option measures how much its premium will change as a result of a $1 move in the underlying stock. If an option has a delta of 1, an increase in the stock price will cause an equal increase in the price of the option. This is called “delta one.”

With a delta of 0.5, investors can expect an increase of 50 cents in the option premium from a $1 rise in the stock price.

“Our goal with those mixed-assets is to create a balance between the equity and the fixed-income component of the structure,” he said.

The 75% barrier in his view did not provide enough contingent protection.

“Pricing a put 25% out of the money is not going to give me a delta of 0.5. My delta is going to be much higher than that.

“The higher the delta the more you should treat this as equity. If the delta is high, the structure becomes very sensitive to the price of the stock.

A delta of 0.5 for a put will enable the “mixed asset” to fit into a 50/50 bond-equity allocation, he explained.

“If I buy an income note for my own purpose I’d want to weight it 50/50. I’d rather have a lower coupon and more protection simply from an asset allocation standpoint,” he said.

Volatility

Volatility is also one of the factors determining the pricing and the risk of breaching the barrier.

The underlying fund has outperformed the S&P 500 index this year. It has gained 2.55% compared to a 0.55% decline in the equity benchmark.

The biotechnology fund has an implied volatility of 23%, which is much higher than the S&P 500’s volatility currently around 13%.

But the notes are structured on a single asset; hence, investors do not incur any dispersion risk.

In addition, the underlying is a fund, which by nature is more diversified than a single stock.

“There are notes like this based on single stocks that are much more volatile than this one,” said an industry source.

“Maybe if you compare it to the S&P 500 it’s volatile. But it’s not more volatile than any of the tech names.”

Wells Fargo Securities LLC is the agent.

The notes will price on May 30.

The Cusip number is 95001B3Y8.

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