I have recently come across a few highly leveraged structured note offerings. One such note that caught my eye was a 5 year note offering 5x the upside performance of the popular Euro Stoxx 50 Index, up to a cap of 94%. The structured note offered no principal protection and exposed the investor to 1x downside exposure.
Why are we interested?
Leverage is a dirty word in securities investing, with good reason – margin investing is a risky enterprise unsuitable for most retail investors due to margin call potential, whereas leveraged ETFs provide the twin dangers of value decay due to daily compounding and leveraged downside.
In contrast, one of the benefits of structured investing is that leverage can be responsibly employed without the typical dangers. For starters, there are no margin calls to worry about. In addition, structured note leverage is not compounded daily, as leveraged ETFs are, but rather operates from inception to maturity. That means if the underlying index increases 10% over the 5 years to maturity, the issuer is obligated to pay out a 50% return (10% * 5x). Thus, there is no decay concern as is typically found in leveraged ETFs.
Furthermore, there is no leveraged downside in this particular investment – whereas it offers 5x upside, there is only 1x downside – not a bad tradeoff!
Let’s do some technical analysis on this offering:
To recap, the characteristics of the note are as follows:
- 5 year term
- 5x upside to a cap of 94%
- 1x downside
As discussed in a previous post, investors in a structured note will not receive the dividend associated with the underlying index (although the missing dividend is accounted for in terms of reduced option pricing – i.e., better investment terms).
Since Euro Stoxx is currently yielding a 3% annual dividend, to analyze this investment we must factor in the 3% dividend not received by an investor who purchases the note rather than a direct Euro Stoxx investment. When comparing performance of the Euro Stoxx and the note, I will add 16% (3% dividend compounded over 5 years) to the value of the Euro Stoxx price return as of the maturity of the note.
For example, if Euro Stoxx increases 5% total over the 5 year period, the note will return 25% (5% * 5x) while an investment in the index would have returned 21% (5% price return + 16% in dividends). The graph below illustrates the returns of the index (inclusive of dividends) with the note.
Chart 1: Euro Stoxx 50 Total Performance vs. Structured Note Performance
As the chart indicates, the note outperforms the index if after 5 years the index finishes up between 4% and 78%.
This note seems to be a desirable strategy if one believes the index is in for a relatively low return over the coming 5 year horizon. For example, a 4% annual return in the index would result in a:
- 38% return for a direct investment in the index
- 94% return for an investment in the note
Table 1: Performance of Euro Stoxx 50 vs. Structured Note
(Superior performance by note vs. index highlighted in grey)
As the table above illustrates, if the index generates less than 1% per year on average (excluding dividends) or generates more than 12% per year on average, an investor is better off purchasing the index directly rather than acquiring the structured note. If the average performance is between 1% and 12%, an investor is better off purchasing the structured note.
The issuer of this note is presumably utilizing a call spread to do so. The call spread in this instance is long the At-The-Money (ATM) call and short an Out-Of-The-Money (OTM) call, in this instance the 118.8% OTM call. This spread is done 5 times resulting in the 94% cap (18.8% * 5x).
In designing this note, the bank chose a particular balance between the amount of leverage employed (i.e., 5x) with the overall cap on the return (i.e., 94%). The bank also had the option to reduce the leverage and increase the cap, and vice versa. Let’s take a look at what happens to the investment outcomes as we increase and decrease the amounts of leverage employed.
Let’s look at the extreme leverage scenario first – a digital call option can be thought of as a very tight call spread with an “infinite” amount of leverage. Essentially, if the value of the price index is positive at all, the investor receives a fixed maximum payout (equivalent to a cap from the prior example) because of the infinite leverage employed.
I have estimated that replacing the current 5x call spread with a digital would result in a cap of 65%. So long as the index returns more than 0%, the note holder with the digital would receive a five year total return of 65%.
Now let’s look at the extreme cap scenario – a reduction in leverage to the point where there is an infinite cap (i.e., no cap) on the upside. If we replaced the current 5x call spread with simple calls, the result would be a 2.1x leveraged scenario with no cap in performance.
Chart 2: Euro Stoxx 50 Total Performance vs. Structured Note Performance
Table 2: Performance of Euro Stoxx 50 vs. Structured Notes
(Superior performance by note vs. index highlighted in grey)
As can be seen in the table above, the digital would allow better performance in a very flat market (due to the infinite leverage) at the expense of underperformance at higher returns (due to the lower cap) while the 2.1x note would allow for better performance in more bullish environments (due to the infinite cap) at the expense of underperformance in low return environments (due to the lower leverage). Ultimately, a note can be created anywhere in between and, in addition, a note can go below 2.1x leverage and introduce a level of downside protection – after all, that is the beauty of structured investing – the ability to create a risk / return profile that specifically matches an investor’s preferences.
In conclusion, while leverage can be a dangerous device in traditional investing, within a structured note leverage can be responsibly employed to enhance returns without introducing some of the traditional associated risks.
Nothing in this presentation should be construed as a recommendation or solicitation. Any security or strategy mentioned is for illustrative purposes only to help provide clarity to the narrative. Because of the nature of structured notes, any specific securities noted cannot be acquired through an exchange market order today or in the future.
 Assuming no credit default
 It is not actually infinite but perhaps a conversation for another time