AUTOCALLABLES, VOLATILITY COMPRESSION AND EUROSTOXX – Horseman Capital – Russell Clark’s Market Views
Autocallables (or reverse convertible securities) are products that first gained popularity in Japan in the 1990s. They are short-term coupon bearing notes, which are designed to enhance yields. Autocallables can be fiendishly hard to understand, as they often have various barriers based on an index which will determine the payout. The simplest way to describe them is that investors use the structured note to sell insurance on the market. As long as the market does not fall too far, the investor keeps the insurance premium. However, if the market falls too far the investor loses both the yield and underlying capital. Autocallables are a feature of a market where domestic interest rates are very low and likely to stay low. Hard data on autocallables is hard to come by, but we have some data from Korea and the US.
Like much of the world, Korea has seen interest rates move relentlessly lower since the financial crisis. In 2007, 10 year Korean bonds offered rates about 5%. Now they are well below 2%. The graph below shows the swap rate which tracks South Korean Government bond yields.
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The interesting thing about structured products are that they are designed to provide investors with yield and similar to bonds, as the price falls, the yield on the products rise. Unfortunately, if the underlying market falls too much, then the product converts from a fixed income product to an equity product.
This leads to structured products normally being a stabilising feature of the market, as they naturally compress volatility, but in moments of extreme stress they amplify volatility as products convert to equity. With products in both US and Korea using European volatility, a European crisis has the potential to spread contagion via autocalls.
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