Autocallable structured note in a with-profits fund: 8.5% is not a yield
Arden Grange is a £1.4bn with-profits sub-fund. The investment committee is considering a £75m allocation to a five-year FTSE 100 autocallable note. Terms: quarterly observation; if the index is at or above its initial level the note redeems early and pays 8.5% a year accrued; coupons of 8.5% a year are paid on any observation date where the index is at or above 70% of its initial level, otherwise no coupon is paid, though accrued coupons are paid on later qualifying dates; at maturity, if the index is below 65% of its initial level, capital is reduced one-for-one with the fall from the initial level. The issuer quotes 98.50. The fund's independent model, using 18% implied volatility, a 3.5% dividend yield and 4.2% risk-free rates, gives 101.20. The manager calls the note 'a high-yield bond substitute with equity upside'. The same bank is already counterparty on £60m of interest rate swaps.
1. Decompose the note's payoff and explain what the investor is really selling. Why is the 8.5% coupon not a yield?
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Decomposition The note is economically: a deposit with the issuer, plus a short position in a strip of digital options that pay the coupon, plus a short position in a down-and-in put struck at the initial level with a 65% barrier, plus the issuer's right to call.
- Conditional coupons. Each quarterly coupon is a digital option on the index being above 70% of its initial level. The investor has sold these.
- The autocall. If the index is at or above its initial level the issuer redeems. That is a call owned by the issuer, exercised when the note has become expensive for them - typically after the index has risen and the remaining coupons are costly. Upside is therefore capped at the coupon stream; the investor never participates in a strong rally.
- The 65% barrier put. The investor is short a put that only bites below 65%. A fall to 50% returns 50% of capital: a 50% loss on a note that paid 8.5%.
The net position is short volatility and short skew: negative delta that becomes more negative as the index falls (short gamma), negative vega, and a payoff that resembles selling equity puts. The return distribution is many small positive outcomes and a small number of very large negative ones.
Why it is not a yield 8.5% is the coupon the issuer is willing to pay for the optionality it is buying from the investor. Expected return = risk-free rate + issuer credit spread − fair value of options sold − dealer margin. On a 5-year note the option package can easily be worth 6–9% of notional, so the expected return may be below cash. A bond's yield is a contractual return to maturity; this coupon is contingent on the path of the index and can be zero. Presenting it alongside credit spreads is misleading.
2. Explain the likely sources of the 2.7-point gap between the issuer's quote and the internal model, and recommend what the committee should do.
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Sources of the 2.7 points (about £2.0m on £75m)
- Volatility surface. A single 18% at-the-money volatility will not price a barrier 35% away with a five-year maturity; spot-down skew can add several points to the short-put value. If the note is priced off a skewed surface and the internal model off a flat one, the internal model is wrong in the risky direction.
- Dividends. 3.5% against 4.0% changes the forward and hence the barrier probability; over five years this is worth a lot.
- Discounting and issuer credit. The internal model may be discounting at risk-free; the issuer's own funding spread (say 90bp) reduces fair value by around 3 points over five years.
- Model type. Local or stochastic volatility versus Black-Scholes, and the treatment of the autocall (longstaff-schwartz style versus a simpler lattice).
- Quote type and margin. 98.50 may be a bid; the dealer's structuring margin is often 1–2%.
- Collateral and funding terms. Whether the note is collateralised under a CSA changes the counterparty charge.
Recommendation
- Do not buy at 98.50 while the firm's own independent valuation says 101.20. That gap is either a model error or a cost, and both need to be identified before the trade.
- Obtain at least three competing quotes on identical terms, plus a component breakdown (deposit value, coupon digitals, put, autocall, margin).
- Have the model independently validated with a skewed surface and the issuer's credit spread, and confirm the valuation policy for an illiquid note - broker quote versus model, and who may override.
- Aggregate the counterparty exposure with the existing £60m of swaps against a single-name limit, and confirm CSA terms and collateral.
- Treat the note as equity risk, not bond risk, in the with-profits fund's risk appetite and in the PPFM disclosure; the capital charge and the equity exposure should be shown on a look-through basis.
- If the exposure is genuinely wanted, consider replicating the payoff with listed options or a direct equity holding with a stop-loss, which is transparent, liquid and cheaper to value.