Faculty column: Risks and rewards of ELS
By Raunaq Pungaliya
Structured products, such as equity linked securities, are customized hybrid investments whose returns depend on a complex combination of debt, equities and exotic derivatives. They are complicated and difficult to value, but hugely popular.
Equity linked securities (ELS) have come far from their modest beginning in 2003, when the Korean Ministry of Finance and Economics first allowed asset management companies to sell them to the public. After falling out of favor in 2008-2009 during the financial crisis, the issuance of ELS in Korea hit record levels this year. Notably, in just the first half of this year equity linked securities worth approximately 20 trillion won ($19 billion) were issued, an increase of 83.8 percent over the first half of last year.
Equity linked securities are not all the same, rather they form a class of securities that are finely customized to cater to demand of a broad investor base with differing risk profiles and yield expectations. In the current low-yield, high-inflation environment, equity linked securities seem attractive to yield-seeking retail investors as they are structured to offer a much higher coupon, often ranging between 8 and 20 percent per year.
But, how do these securities work? What are the drivers of this excess yield? What are the risks that investors and issuers face? And under what circumstances do they add value?
Given the diversity of investment options available under ELS, this case focuses on one of the most popular ELS variants in Korea technically known as a worst-of two-asset autocallable reverse convertible.
The worst-of two-asset autocallable reverse convertible (RC)
This complex reverse convertible security promises a coupon that is contingent on the performance of the two underlying stocks or stock indices. The reverse convertible can either be automatically called at certain redemption intervals or expire at maturity.
Let’s consider each case separately. The auto-call feature terminates the contract if both underlying assets have values greater than the strike price at the redemption date. If the contract is terminated early, the investor receives his principal along with the promised coupon payment adjusted for the holding interval. If the contract extends to maturity, the investor’s coupon and principal payout is contingent on the path of the two underlying assets. If the price of both assets remains above the knock-in barrier level specified in the contract, the investor receives his principal and coupon as promised. On the other hand, if the price of either asset falls below the barrier during the contract period, it automatically activates a put option that allows the issuer to pay out a return equivalent to the worst return of the two assets.
In good states of the world (where the barrier is not breached), the structure acts like a debt instrument as the investor receives his principal along with the promised coupon payments. Conversely, the investor can be saddled with large losses in bad states (if the barrier is breached). Another way to think of this is that the investor acts like an insurance company, wherein he collects a premium in good states to enhance his yield, but agrees to payout in bad times.
It is important to note that fundamental finance principles of no free lunch and the risk-return relationship apply just as well to complicated securities as they do to simple ones. It is easy to see that the structure’s valuation critically depends on the probability of hitting the knock-in barrier. All other things being equal, higher coupons are associated with a greater risk of barrier breach and capital loss. Thus a barrier set at 80 percent of current value will be associated with a much higher coupon compared to the same product with a deeper barrier set at 50 percent.
Moreover, the maximum promised yield understates the risk as it is lower than the fair value yield generated by the bank’s proprietary model. This difference between the bank’s fair value and the yield offered to the investor accounts for one source of the bank’s profit margin on the product.
Given the depth of the market for these products in Korea, the investor has access to a wide range of underlying assets. Clearly, the choice of the underlying assets will have a bearing on the coupon offered. Higher volatility of the underlying assets increases the risk of breaching the barrier; and equivalently increases the coupon rate.
In addition, in the worst-of two-asset case, underlying assets with a low correlation are more risky than the assets with high correlations because a breach of the barrier by any asset can trigger a potential loss. Similarly, increasing the number of underlying assets does not reduce the possibility of loss by diversification but amplifies it. Thus, a worst-of structure with two underlying securities is less risky than one with three underlying securities.
Furthermore, while the returns on this product are linked to the underlying assets, they are obligations of the issuer. The investor is also exposed to counterparty risk of the issuer concerned.
This structure is designed for sophisticated investors who are yield-seeking but are willing to bear significant downside risk. The target investor is moderately optimistic about the underlying assets and bets that their value will remain range bound or go up. The investor also believes that the two assets will have low volatility and a high correlation.
This structure is inappropriate if the investor believes that the underlying assets will appreciate significantly as it would be more efficient to directly hold the underlying assets instead. Clearly, this structure is also inappropriate if the investor believes that the underlying assets may substantially decline in value.
Conversely, as the issuer’s cash flow stream is exactly opposite to that of the investor, it can be said that it holds the opposite market view. However, in most cases issuers partially or completely hedge their exposure and are view-neutral. In these cases, the counterparty to the hedge holds the opposing view.
Lessons / caution
Remember that the payoff to these securities is similar to insurance for crash risk: decent premiums in good times, with a large payout in bad times. This is opposite the typical case where the bank insures the investor from bad outcomes. As the value of cash is higher in bad times than in good times, realize that this product may make you worse off when you may need it.
While evidence on the Korean market is scarce, several studies in markets such as Switzerland and the Netherlands where similar structured products are popular have documented significant overpricing of structured securities marketed to retail consumers. In the U.S., reverse convertible securities were recently highlighted by FINRA, a financial regulatory body, as complicated instruments requiring extreme caution and litigation between issuers and investors is ongoing.
As the Korean market has unique characteristics, the implication of issues in overseas markets on Korean retail investors is unclear. For example, the introduction of deep barriers in Korean two-asset reverse convertibles have reduced coupons, but also reduced risk.
However, prudent investing rules suggest that investors should refrain from investing in structures that a) they do not completely understand, b) cannot fairly value and c) are beyond their risk-tolerance limits.
Sophisticated investors who understand the risk-reward tradeoffs embedded in these securities, have a clear market view and find a well-priced product with low fees can benefit from including these in their diversified portfolio.