Russell Clark is a former Chief Investment Officer at Horseman Capital, and is now the author of Capital flows and asset markets Newsletter, where a version of the following was initially run. We’ve been obsessed with the auto-callable market for a while, so we asked Russell to reallocate some of his work to FT Alphaville readers.
The post-financial crisis period of low interest rates has led to an explosion of savings products engineered for customers desperate for steady returns. But as interest rates rise, some of these financial structures are beginning to collapse.
Auto-order items – or structured products as they are known in Europe – are a model of the unconventional vehicles that thrived in the period of low interest rates and now seem to be ending.
They are products primarily sold to retail investors as a yield-rich alternative to extremely low deposit rates. A typical structure includes offering a 5 to 10 percent yield payout as long as some large benchmark stock indices don’t go down more than 40 percent or rise more than 10 percent.
If the index drops 40 percent, the product changes from a yield product to a stock product, and you will lose 40 percent of your initial capital. If the index rises by 10 percent, the payout stops, and you get your entire capital back.
Automatic materials are popular globally, but the prominent market in recent years has been South Korea, where recently it has greatly spread in popularity. Despite its population of only 50 million, South Korea’s auto-order market is close in size to Europe or the United States.
The payout on the auto call option comes from the index’s underlying dividend yield, and then the amount of premium that can be generated by selling. For simplicity’s sake, the higher the VIX (or local equivalent) the higher the return that can be achieved.
I like to think of Auto Collectibles as a distributor wallet insurance market. But what does this mean?
When a trader wants to hedge his position, he often buys positions in the market. Historically, the other side of this trade would be a pension fund or some other long-term investor who would be willing to buy the market at that level, if it should go down, and love collecting coupons in the meantime. However, seasoned investors may want a hefty premium for bearing the risk, so the cost of insuring the portfolio has been relatively high. Orderable items – especially Korean allotments – changed the balance of the market.
Individual investors will buy a return product, usually rolling over the products when they expire, in fact constantly selling the products. This means that the balance of the market began to shift from sellers to buyers of insurance, and the hedging price of the portfolio fell significantly.
Stock-linked auto-order products started booming in 2013-2014, above all in South Korea. The influx of willing buyers helped suppress implied volatility in the South Korean stock market. The Kospi 200 Vix Index was normally used to trade between 20 and 30 since its inception until 2013, but until the Covid-19 hit, it was rarely trading above 20.
So how can we be sure that the presence of auto-order susceptibility causes market volatility to decrease and then rise when it disappears? Fortunately, we have a working example.
In 2014 and 2015, the South Korean Vix index fell to 10, which means that the return on only Kospo 200 products has become unattractive to Korean retail buyers. So the financial engineers turned to the Hang Seng Index of Chinese companies, which saw much higher volatility – and hence the return.
In NICE’s 2014 Annual Pricing and Market Information Report, HSCEI was included in five of the top six products, which were 60 percent of all issued products. Just as in South Korea, the HSCEI Vix Index – which rarely trades below 20 – started falling, touching its post-financial crisis low of 15 on June 2014.
However, HSCEI is a very private market. They are priced in Hong Kong dollars, but the underlying assets are exposed to Chinese yuan risk. This means unlike other markets, currency risk is a big deal. In 2015, devaluation fears hit the market and the HSCEI fell 49 percent from peak to trough, creating a number of automatically expellable barriers.
This sounds technical, but in the simplest terms, retail investors sold insurance in the market, and the people who bought the insurance asked them to do good. So if you pay KRW 100 to get 5 percent of the HSCEI-linked automatic return, you’ve gone from having a good money product to suddenly facing a 30-40 percent capital loss.
Most auto-orderable products are simply rotated when they reach the ascent barrier, but when there is a lost demand for the product it disappears for a while. Despite this, the Korean auto-demanding version was down 50 percent in 2015, and without a release, the HSCEI Vix returned to its previous range of essentially trading between 30 and 40.
With rising interest rates, could the auto-callable issue slow down or even disappear, and volatile markets return to the pricing dynamics that prevailed before the financial crisis? And if so, in which markets have Korean investors been selling portfolio insurance recently?
According to the NICE P&I 2022 semi-annual report, the top index was the S&P 500. So how can the auto-callable dynamics now affect the US stock market?
In contrast to the HSCEI market, there is less risk for live currencies. But Standard & Poor’s has interest rate risk. As Treasury yields rise, the attractiveness of S&P dividends declines. If we go back to late 2018, which was the last time the Federal Reserve tightened monetary policy, the implied dividend yield on the S&P index was re-priced from 1.8 percent to 2.3 percent. cent. Today, 10-year US Treasury yields are about the same as they were back then, but the implied dividend yield for the S&P 500 is 1.6 percent and back to 2.3 percent would require the S&P 500 to fall 30 percent. cent. This repricing will have the additional negative effect of knocking down barriers and forcing VIX higher, and the S&P even lower.
Low returns prompted a massive retail influx of auto-order items. This created a direct link between implied volatility and interest rates. With inflation returning and yields rising, selling volatility by auto-orderable items is likely to slow down slowly at first, then rapidly as a violent rise in volatility causes markets to break through barriers.
With other auto-callable markets such as HSCEI and Kospi 200 down 30 percent or more from heights and likely near barriers, auto-call risks are rising rapidly.
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