Called Callables and Other Riddles, A Late Summer Review

 In All, Deconstructed Notes

With Labor Day quickly approaching and summer coming to a close, it seems like an opportune time to provide an update on some of the prior stories we have featured.

One of the trends we have focused on are callable products.  The reason we have tried to shine a light on this area is that structured call features tend to result in nice headlines featuring attractive long term appreciation potential, but in reality often result in returns or exposures which are less attractive for one reason or another.

Callable features are often associated with corporate bonds and typically allow the issuer an option to refinance early. The bonds usually cannot be called for several years, giving investors the opportunity to enjoy a slight premium in term of yield for an extended period of time.  Structured notes with call features similarly result in a premium to the investor, allowing an optically favorable looking headline rate. However, unlike corporate bonds, they are often callable relatively early, such as after a single quarter has elapsed.

The first callable note we featured was on Hertz and had an annual yield of 15% and a two year term, which points to a 30% potential gain on the investment. The note ended up being called at the first opportunity, resulting in only a 3.75% payout after three months. While this quarterly payment provides the same annualized yield as the headline, the short duration introduces other concerns to the investor – for instance, the effort of placing this trade vs. a 3.75% payout and the need to find another investment after a short period of time.  As mentioned in the post, the early call was an expected outcome with roughly 75% of simulated scenarios resulting in it being called. The question a potential investor may ask is whether these sorts of trades makes sense –  in this case, the investment headline was a 30% payout over two years against the risk of Hertz declining 30% (which sounds great in this environment), but serious consideration should be provided to the likelihood of being called after three months and the implications of the early investment termination.

Another callable we explored was one on Vertex Pharmaceuticals (VRTX).  This was an interesting one as the headline yield was a high annualized 11% with a barrier at maturity providing contingent protection of 45%.  This investment introduced two items an investor needed to be aware of – first, it was callable, similar to the one on Hertz discussed above, and thus investors were unlikely to see the 11% yield for long.  In addition, there was another investor concern affecting this note – there was a major binary event on the horizon.  What investors might not have realized is the high likelihood that if the binary event did not go the company’s way (it was a Stage III study), the stock would have a high probability of plummeting below the barrier.

To put things in perspective, if the same structured note was created today on VRTX, the terms would be a 9.4% yield vs a barrier at maturity down 20% (another note discussed in the same blog had these very same characteristics and was issued against a more recognized name, Linkedin (LNKD), but only raised 5% of the notional of the VRTX note, presumably due to the inferior headline characteristics). Ultimately, VRTX dropped 20% prior to the binary event and then soared 50% in one day based on positive Stage III results. This note was called as of August 21, resulting in a 5.5% payout for the investors of the notes. Hopefully the investors had strong stomachs as I am not sure they understood what they were getting into.

Moving away from callable notes, we also decided to deconstruct a couple of structured CDs.  One that caught our attention was a CD with a basket of 10 stocks. The term on the CD was 4 years and the investor could max out at 5% per year if the underlying stocks performed well. Considering the low rate environment, and the guaranteed principal protection, a 5% yield sounded great. Unfortunately, as we pointed out in the article, the odds are greatly stacked against the investor actually capturing 5% in any single year. The basket was designed asymmetrically, such that a losing stock could potentially have far more impact than a winning stock – in fact, one big loser would wipe out the gains of 5 strong stocks in any given year.

Not surprisingly, as we predicted in the blog, the investment has for the second year in a row made payments of only 2%. It seems unlikely that the CD will pay anything more than 2% going forward given the ground that one the stocks in the basket, ABX, would need to cover to get into positive territory. I believe there is some risk that the payout can approach 0% next year if the market ends up flat, despite the fact that cumulatively to this point, the basket is up roughly 30%.  This note represents another type of investment opportunity that investors should consider carefully before investing in.

Thanks for reading – please return to your beach chairs and pina coladas.  I look forward to bringing additional deconstructions, analysis and education to the space after Labor Day – until then, have a great long weekend and enjoy the last weeks of summer!


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