Auto-Callables
Auto-callables are complex savings instruments that offer a bond-like fixed return, crafted by selling stock options.
Key Takeaways – Auto-Callables
- Auto-callables are savings instruments that offer fixed returns similar to bonds, created by selling stock options, primarily on broad stock market indices.
- They attract investors with their potential for higher yields and early redemption based on the performance of the underlying asset.
- If the asset underperforms, investors risk receiving lower returns or losing part of their principal.
- Particularly popular in Asia, auto-callables provide an alternative to traditional savings – especially in regions with a history/current cultural proclivity against investing in equities and riskier forms of bonds/credit.
Background
Historically, the options sold have predominantly been on broad stock market indices, such as the S&P 500, Hang Seng, or Nikkei.
However, especially in times of falling market volatility, bankers may structure auto-callables with options on individual stocks. These tend to be more volatile and present a different risk-reward profile compared to broad indices.
Auto-Callables and the Attraction of Fixed Returns
The primary draw of auto-callables is their ability to offer investors an attractive, fixed return that bears resemblance to the payouts from bonds.
Bankers construct these returns by selling call options against a long position in the underlying stock (a call option).
This generates premium income which can be used to provide the payouts that attract investors to the product.
Risks of Auto-Callables
If the underlying assets perform unfavorably, the auto-callable can be automatically redeemed, or “called,” by the issuer.
Like with standard covered call trades, if the fall in the underlying asset is more than the income being received on the option, it results in a net loss for the investor.
Asian Affinity for Auto-Callables
Auto-callables are most popular in Asia.
They offer higher returns compared to traditional savings vehicles (in exchange for more risk).
In Asia, investing in stocks and riskier forms of bonds is not as popular as it in the US and Europe.
Some countries don’t have the history, like China and Vietnam, so there’s less understanding of these markets. (Savings in these countries has traditionally been in the form of cash, gold and precious metals, and other real assets.)
However, even in Asian countries with a longer history of capitalism and free markets, traditional stock and risky bond investments are not popular due to experiences.
In Japan, due to a terrible drawdown in their equity markets starting in 1989 – and lasting for decades – there’s also a reluctance to put a lot of savings in equities.
Data from the Bank of Japan shows that Japanese households allocate a mere 11% of their savings to stocks, while maintaining a 54% in cash and bank deposits.
This allocation is significantly different from that in the United States, where, according to Federal Reserve data, households invest approximately 39% of their funds in the market, keeping only 13% in cash and bank deposits.
FAQs – Auto-Callables
What are auto-callables?
Auto-callables are structured products that automatically redeem before maturity if the underlying asset meets certain predefined conditions.
They are structured as covered calls, typically of a broad stock market index, but can include individual stocks as well.
How do auto-callables work?
They work by monitoring the performance of an underlying asset, and if the asset reaches a specified level or condition, the auto-callable is redeemed automatically, often with a predetermined return.
What are the benefits of using auto-callables?
The benefits include potentially higher yields compared to traditional bonds and the possibility of early redemption if the underlying asset performs well.
For example, if a stock does well, the call option that was sold against the stock may be exercised, leading to the closure of the position.
What are the risks associated with auto-callables?
The primary risk is that if the underlying asset underperforms, investors might receive a lower return or even lose a portion of their principal.
How are auto-callables different from regular callable bonds?
Both can be called back by the issuer, but auto-callables are automatically redeemed based on the performance of an underlying asset.
Callable bonds are redeemed at the issuer’s discretion.
In what financial scenarios are auto-callables commonly used?
Auto-callables are often used in low-interest-rate environments where investors seek higher yields and are willing to take on more risk.
How can an investor purchase or invest in auto-callables?
Investors can purchase auto-callables through financial institutions, brokers, or investment banks that offer these products.
What factors influence the pricing of auto-callables?
Pricing is influenced by:
- the performance of the underlying asset
- interest rates
- market volatility, and
- the specific terms and conditions of the auto-callable
Can auto-callables be redeemed before maturity?
Yes, they can be automatically redeemed before maturity if the underlying asset meets the specified conditions.
What happens if the underlying asset of an auto-callable underperforms?
If the asset underperforms, investors may receive a return lower than expected.
In some cases, they might lose a portion of their principal.
Are there any fees or charges associated with auto-callables?
Yes, there might be fees or charges.
These vary depending on the issuing institution and the specific product terms.
How do interest rates impact the performance of auto-callables?
Higher interest rates can make other investments more attractive (e.g., cash, regular bonds), potentially reducing the appeal of auto-callables.
Lower rates can enhance their appeal due to the potential for higher yields.
What are the tax implications of investing in auto-callables?
The tax implications vary by jurisdiction.
But generally, any returns or interest earned from auto-callables are subject to tax.
Investors should consult with a tax professional or financial advisor for specific guidance.