Where the Traders At - Market Linked Step Up Notes
Big banks and brokers offer a suite of investments to their most valued customers. There seems to be something fundamentally not free markets about having access to deeply discounted investments that would otherwise trade higher in the open market. Take for example Market Linked Step Up Notes.
Market Linked Step Up Notes trade using a set of terms based on some underlying index. I know that super high net worth Merrill clients have access to these things at origination. While the terms can vary, a traditional structure is as follows:
1:1 downside on S&P, 15% gain when the S&P is up between 1% and 15% and 1:1 upside for underlying increases above 15%, 1 year tenor, BAC counterparty (counterparty risk).
There is a liquidity premium here, however, the original buyers are getting a steal. They are able to buy in well below the security’s intrinsic value. The Market Link Security described above trumps a S&P buy and hold strategy in all scenarios, implying that in an efficient market the security would have to trade above par at issue (not accounting for liquidity or counterparty risk premium).
Questions I pose for you the WS Oasis Community:
1. Who is on the other side of this investment at origination? Is the bank using these notes to raise temporary capital or are they feeding it to institutional investors?
2. I know these are illiquid, but how can you find a record of these securities and terms?
3. Anyone know a broker that would let you short the S&P and go long one of these securities at origination?
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Structured Notes like this
Structured Notes like this are build with derivatives, so the package can be broken down and sold to different counter parties.
These notes are also very expensive for the client.
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Market Linked Step Up Notes
Market Linked Step Up Notes trade using a set of terms based on some underlying index. I know that super high net worth Merrill clients have access to these things at origination.
http://www.inkcarts.com
Interesting - never heard of
Interesting - never heard of these....
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Merrill is having their fa's
Merrill is having their fa's push these like crack.
I didn't see you mention that these are bonds issued by mostly banks (not sure what their credit rating is) and instead of interest you get exposure increased/decreased by the index link and locked up a few years (or whatever term you choose) but if sold prior to maturity you take a large hit. The default risk is therefore embedded into the link along with lockup period.
I can get you access to some brochures etc. I know fa's can discount, LIKE ANYTHING ELSE, the rates/fees/commissions.
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Another more interesting
Another more interesting version of these products are the market linked cds, which carry FDIC insurance. They allow for capped upside gain or semi-annually averaged upside gain linked to some index or basket of commodities. However their downside is zero loss of principal or even sometimes a minimum return like .5% apy as long as you hold until maturity. The catch is that they are longer term investments 5-6 years minimum. There is generally a large upfront fee ~3%, but you are guaranteed to get that back plus any minimum interest. I worked in WF private bank and they sold like hotcakes, because most people don't trust their brokers and are more interested in return of principal even at the cost of future gains.
BCbanker: Big banks and
Big banks and brokers offer a suite of investments to their most valued customers. There seems to be something fundamentally not free markets about having access to deeply discounted investments that would otherwise trade higher in the open market. Take for example Market Linked Step Up Notes.
Market Linked Step Up Notes trade using a set of terms based on some underlying index. I know that super high net worth Merrill clients have access to these things at origination. While the terms can vary, a traditional structure is as follows:
1:1 downside on S&P, 15% gain when the S&P is up between 1% and 15% and 1:1 upside for underlying increases above 15%, 1 year tenor, BAC counterparty (counterparty risk).
There is a liquidity premium here, however, the original buyers are getting a steal. They are able to buy in well below the security’s intrinsic value. The Market Link Security described above trumps a S&P buy and hold strategy in all scenarios, implying that in an efficient market the security would have to trade above par at issue (not accounting for liquidity or counterparty risk premium).
Questions I pose for you the WS Oasis Community:
1. Who is on the other side of this investment at origination? Is the bank using these notes to raise temporary capital or are they feeding it to institutional investors?
2. I know these are illiquid, but how can you find a record of these securities and terms?
3. Anyone know a broker that would let you short the S&P and go long one of these securities at origination?
These do not outperform in all scenarios. If BAC goes bankrupt, this thing is virtually worthless. This is not nearly as good of a deal as it seems. First, the investor does not receive dividends. Second, the liquidity is terrible. Third, the payoff only applies at maturity, even if you received a fair bid on your note 6 months into it and the market was up 8 percent, you wouldn't have an 8 percent return.
The bank manages the delta position they are short to the investor. Trust me, they are not giving you something for free here. Think of it like this, if you sell an at the money put and have all of your money in BAC 1 year paper, that generates something like 10-12% in premium received, including BAC credit spread. Now you buy a 115 strike call for about 1% premium. With the balance of the proceeds, you can buy a 101 strike digital option wih a 15 point payoff which will allow the desk to lock in their P&L (taking the P&L upfront for bonus calcs).
Keep on mind, his will all be done synthetically. The desk will try to offset as much of this risk as they can wih other options trades they have done with hedge funds and the like. Clearly, BAC is giving better prices to hedge funds hey are trading with than Mom and Pop in a structured note, not because they like hedge funds better, but because funds run a competitive process for pricing with multiple banks.
I'm sure a Merrill broker would gladly sell you this, collect his 2% commission and let you short SPY and collect more commissions.
I haven't done this in a whole, but you can search for deals on Edgar by S-1 filings for registered deals. You just need to find the issuing entity (all banks have tons of entities and thy have one or two that they issue structured notes out of in the US).
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SirPoopsaLot: Keep on mind,
Keep on mind, his will all be done synthetically. The desk will try to offset as much of this risk as they can wih other options trades they have done with hedge funds and the like. Clearly, BAC is giving better prices to hedge funds hey are trading with than Mom and Pop in a structured note, not because they like hedge funds better, but because funds run a competitive process for pricing with multiple banks.
I'm sure a Merrill broker would gladly sell you this, collect his 2% commission and let you short SPY and collect more commissions.
Great response. A thought and a question for you.
The Thought "Counterparty Risk": So I do understand that counterparty risk here is priced in, however that doesn't justify any price. For one, this the tenor is only one year. You can get a proxy for counterparty risk using a one year BoA bond. They don't trade at 12%.
Question "Do you think this trade would work": Short $1MM S&P, use proceeds to buy $1MM Market Notes. What does my PnL look like? I lose transaction costs and the S&P dividend? I gain on the accelerated upside if not is in the black? What collateral do you think you would need to put down (i.e. max loss is dividends + transaction costs), so maybe only 5% down?
By my calculations if you put 5% down ($50k), pay 2% trans fee and say 2% dividend the payouts are as follows.
S&P decrease = Lose 40k or 80% loss (loss of transaction costs and dividends)
S&P up .01%-15% = Gain $110k (net fees) or 220% gain (no that this errodes at gain approaches 15%)
S&P up > 15% = Lose 40k or 80% loss (loss of transaction costs and dividends)
Assume that these payouts are somewhat normal and I think you will get a positive NPV (S&P moves 1-15% in a year 40-45% of the time)
Also, think of it like this.
Also, think of it like this. If the market is down, you would underperform a direct investment by about 2% (the dividend yield). If the market is up more than 15%, you underperform by 2% (also the dividend yield). If I understood the structure correctly, you would get 15% if the market was 1% higher or more. So, your breakeven is 13% compared to a direct investment which pays dividends. There just aren't many scenarios where you win and when you do, it's only by a little bit.
Plus, you took on a ton more risk. Don't love that.
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Can you explain your 80% loss
Can you explain your 80% loss given S&P up > 15%... I saw 1:1 upside for S&P > 15%, and if youre short the S&P for 1mm wouldnt you only suffer transaction/dividends losses?
disregard that last comment,
disregard that last comment, apologize for that. and this work computer not letting me see the delete comment icon
Double post
Double post
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i have about a quarter of my
i have about a quarter of my portfolio in structured products -- certain ones are sexy. i have one written from may 2011 that offers me a 17.8 percent return in may 2013 as long as the spy is above 131.64
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I'm a fixed income trader at
I'm a fixed income trader at a BB and we do a lot of these things. They're not inexpensive- you're taking outright credit risk to the issuer, so for a 5y investment you should probably receive at least a 2-4% return to begin with. On the derivative, god knows how much you get charged. There might also be some additional cost since the bank will likely hedge the derivative under a CSA but obviously your note is uncollateralised. Depending on the wrong-wayness of the derivative, the bank will charge you more.