Autocallable

It’s time we had The Talk.

Candid discussions can be uncomfortable. They broach subjects we prefer to avoid. But we can’t ignore the facts of life.

One such fact is Contingent Absolute Return Autocallable Optimization Securities. We’re more comfortable talking about diarrhea, right? Bring them up at a party and the crowd disperses. Try talking to your teenager about them and she’ll roll her eyes and turn up One Direction in her ear buds.

Why the public disdain? Look at the name. Need we say more? They’re wildly popular though with issuing banks including JP Morgan, UBS, Barclays, Morgan Stanley, RBC and others – just about anyone who offers “structured products.”

This particular version of structured product (“a financial instrument crafted by a brokerage to achieve a particular investment objective for clients ranging from short-term yield to long-term risk-mitigation” is how we’d describe them) achieved both infamy and scrutiny after Apple shares slumped in latter 2012. Big banks had sold hundreds of millions of dollars of Contingent Autocallable Securities paying a yield of about 10% and tied to the performance of Apple shares. Buyers got stuck with shares that had dropped 30% in value and lost principal to boot.

I’ll give you my simplest understanding of how these instruments work and why you should care from the IR chair. It’s a debt instrument and it’s unsecured. It tends to pay high interest, like 10% annualized in a basis-points world. Whether it pays out turns on two things: How long you hold it, and whether the underlying equity to which it’s paired declines below a trigger price.

There are two problems for IROs. First, because regulators consider it debt, if it “converts” there’s no equity trade. These things are not responsible for big percentages of volume so there’s no vortex looming in your share-counts. But still, decisions and strategies impacting shares are resulting from instruments you can’t track.

The second problem is that whatever your investment thesis, yield-seeking investors and speculators could be ignoring it and playing your shares. As we’ve written before, shorting in markets is rampant today and unnoticed in short interest because that snapshot misses about 90%. The recent market average is 44% (versus about 3% short interest in the S&P 500). Traders could buy Contingent Autocallable Securities and short the associated shares.

And as David Landes, CEO of BondsOnline Group, wrote at Seeking Alpha in February last year, it’s a hedge for market-makers (and even large investors taking the other side of these trades) with exposure to popular stocks benefiting from speculative hype. If these go down, brokers and big investors dump shares on the unsuspecting – relieving themselves of a liability and adding to downdrafts when momentum money flees.

What can you do in the IR chair? For one, you should know when behaviors that aren’t rational are dominating your price – which will happen whether you know it or don’t (lots of IROs say “I just ignore the market and tell the story” – imprudent, and unnecessary, today).

Second, know your short volume. High short volume, weak investment – you could have this instrument in your market. So proactively cultivate an array of value relationships to call on like doctors (value money loves dips, which you cannot control but can predict with Market Structure Analytics) in the event everyone leaves at once.

And speaking of leaving, Karen and I are off to loll around the waters of the Caribbean contemplating life’s large questions. Well, mainly to loll. We’ll tell you in early June about our adventure!