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Russell Clark is the former chief investment officer of Horseman Capital, and now the author of the Capital Flows and Asset Markets newsletter, where a version of the below initially ran. We’ve been obsessed with the autocallables market for a while, so we asked Russell to repurpose some of his work for FT Alphaville readers.
The post-financial crisis era of low interest rates triggered an explosion of engineered savings products for customers desperate for steady returns. But as interest rates rise, some of these financial structures are beginning to creak.
Autocallables — or structured products as they are known in Europe — are a typical of the funky vehicles that flourished in the low interest rate period that now looks like it is coming to and end.
They are products mainly sold to retail investors as a yield-rich alternative to rock-bottom deposit rates. A typical structure involves offering to pay a 5 to 10 per cent yield as long some large benchmark equity index does not fall more than 40 per cent or rise more than 10 per cent.
If the index falls 40 per cent, then the product changes from a yield product to an equity product, and you lose 40 per cent of your initial capital. If the index rises 10 per cent, the yield payments stop, and you get all of your capital back.
Autocallables are popular globally, but the standout market in recent years has been South Korea, where they have absolutely exploded in popularity lately. Despite a population of only 50 million, South Korea’s autocallable market is close in size to Europe or the US.
The yield on an autocallable comes from the underlying dividend yield of index, and then the amount of premium that can be generated by selling puts. For simplicity, the higher the VIX (or local equivalent) the higher the yield that can be generated.
I like to think of autocallables as a distributed portfolio insurance market. But what does that mean?
When a trader wants to hedge their position, they often buy puts on the market. Historically, the other side of that 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 fall, and liked collecting coupons in the meantime. However, sophisticated investors would want a hefty premium to bear the risk, so the cost of portfolio insurance was relatively high. Autocallables — and particularly Korean autocallables — changed the balance of the market.
Retail investors would be buying a yield product, and typically rolled over the products as they expired, in effect constantly selling puts. This meant the balance of the market started to shift from sellers to buyers of insurance, and the price of hedging a portfolio fell substantially.
Equity-linked autocallable products started to boom in 2013-14, and above all in South Korea. The flood of willing buyers helped suppress the South Korean stock market’s implied volatility. The Kospi 200 Vix Index used to typically trade between 20 and 30 since its inception and until 2013, but until Covid-19 struck it has rarely traded much above 20.
So how can we be sure the presence of autocallables cause market volatility to fall and then rise when they disappear? Fortunately, we have a worked example.
In 2014 and 2015, the South Korean Vix fell to 10, which meant that the yield on Kospo 200-only autocallables became unattractive to Korean retail buyers. So the financial engineers moved on to the Hang Seng Chinese Enterprises Index, which had a much higher volatility — and therefore yield.
In the NICE Pricing & Information 2014 Annual Report on the market, the HSCEI was included in five of the top-six products, which was 60 per cent of all issued products. Just like in South Korea, the HSCEI Vix — which had rarely traded below 20 — starting declining downwards, and touched a post-financial crisis low of 15 in June 2014.
However, HSCEI is a very special market. It is priced in Hong Kong dollars, but the underlying assets are exposed to Chinese yuan risk. That means unlike other markets, currency risk is a big deal. In 2015, devaluation fears hit the market and the HSCEI fell 49 per cent from peak to trough, triggering a number of autocallable barriers.
This sounds technical, but in its simplest term, retail investors had sold insurance on the market, and the people who bought insurance asked them to make good. So if you paid 100 Korean Won to get a 5 per cent yielding HSCEI linked autocallable, you went from having a money-good product to suddenly facing a 30-40 per cent capital loss.
Most autocallables products are simply rolled over when they hit the upside barrier, but when there is a loss demand for the product disappears for a while. Lo and behold, Korean autocallable issuance fell by 50 per cent in 2015, and without issuance, the HSCEI Vix reverted to its previous range of mainly trading between 30 and 40.
As interest rates rise, could autocallable issuance slow or even disappear, and the volatility markets revert to the pre-financial crisis pricing dynamics? And if so, in which markets have Korean investors being selling portfolio insurance on lately?
According to the NICE P&I 2022 semi-annual report, the top index has been the S&P 500. So how could autocallable dynamics now affect the US stock market?
Unlike the HSCEI market, there is less direct currency risk. But the S&P does have interest rate risk. As Treasury yields rise, the attractiveness of the S&P’s dividend stream declines. If we go back to late 2018, the last time the Federal Reserve tightened monetary policy, the implied dividend yield on the S&P repriced from 1.8 per cent to 2.3 per cent. Today the 10-year US Treasury yields roughly the same as it did back then, but the implied S&P 500 dividend yield is 1.6 per cent Moving back to 2.3 per cent would require the S&P 500 to fall 30 per cent. This repricing would have the added negative effect of knocking in barriers and forcing VIX higher, and the S&P even lower.
Low yields drove the mammoth retail flow to autocallables. This created a direct link between implied volatility and interest rates. As inflation returns and yields rise, the selling of volatility by autocallables is likely to ease slowly at first, then rapidly as a violent rise in volatility cause markets to break through barriers.
With other autocallable markets like HSCEI and Kospi 200 down 30 per cent or more from highs and likely near barriers, the autocallable risk is rising rapidly.
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