The days when financial markets moved consistently in only one direction are long gone. The increasingly rapid movements, such as those seen recently in the Corona pandemic or the change in the interest rate cycle, demand maximum flexibility from investors. Timing, targeted stock selection and hedging instruments are therefore becoming more important. But there is a simpler way: With yield enhancement products, promising investment solutions are available that offer real added value in sideways-trending market phases. In the often tough price trends, they succeed in getting the best out of the situation. The strategy can be implemented effortlessly with the different variants of the reverse convertible, which is popular in this country.
Interest rate hunters beware: Reverse convertibles offer a fixed coupon that is usually far above the level of classic bonds or even the interest rate on the money market. However, the risk is somewhat higher, because the repayment of the nominal is not guaranteed but linked to a condition. It depends on the price performance of the underlying asset. At maturity, for example, the underlying may be delivered instead of the nominal being repaid if the price of the underlying closes below the strike price. The coupon, on the other hand, is certain to be paid out.
Before we go into the intricacies of the reverse convertible and its cousin, the barrier reverse convertible (BRC), the largest product type on SIX in terms of numbers, let's first take a look behind the scenes of the products. The basic structure of a reverse convertible consists of a bond and the sale of a put option (short put) on the underlying asset. In the case of a BRC, a bond is also acquired, but at the same time a down-and-in put option is implicitly sold to the issuer. The knock-in threshold of the put represents the barrier of the BRC. The proceeds from the respective sale of the option are in turn largely passed on to the investor in the form of a coupon. At the same time, the guaranteed coupon also indicates the maximum yield to be achieved at issue. The risk can be dosed by selecting the barrier for activating the put option, i.e. the option is only activated when the underlying touches the barrier (down-and-in). Otherwise, the put option expires worthless. The barrier also has an influence on the potential return. For example, if the barrier distance is reduced, the guaranteed coupon is higher - and vice versa.
However, the level of the coupons also depends on other factors. For example, they can vary depending on the choice of maturity and also the underlying assets. Implied volatility and dividend expectations are particularly important. In the case of so-called multi-structures, i.e. products that refer to several underlyings, their correlation with each other is an additional factor. But first things first: The fluctuation range expected by the market determines the premium of the put option. As a rule of thumb, the higher the implied volatility of the underlying, the higher the proceeds. Or to put it another way: the more lavish the coupon. Therefore, the conditions for offensive underlyings are more attractive than for defensive underlyings.
The forecast profit distributions of companies also play a role in the design of yield enhancement products. The more generous the corporations are, the more attractive the structure of the BRCs. And as already mentioned, in the case of multi-structures, the correlation between the underlyings is an additional factor. If this is lower, the product conditions are more attractive than for underlyings with a high correlation. The reason is relatively simple: if the correlation between the underlyings is lower, the probability of a negative outlier is higher than if the underlyings are quasi-same.
To make the products even more attractive, the function of an "early redemption", known as a "callable" in technical jargon, can also be integrated into the structure. In this case, the issuer has the right, but not the obligation, to redeem the product early on predefined dates (usually quarterly or semi-annually). The situation is somewhat different with the "Autocallable" product supplement. In this case, the product is redeemed early if the predefined condition (autocall trigger level) occurs on the observation date. In both cases, the pro rata coupon is paid out in addition to the full denomination. On an annual basis, the investor has then achieved the maximum return despite early maturity.
Despite all the advantages, the risks must not be disregarded. For example, before buying, investors should bear in mind that they are taking on an equity risk and that under certain circumstances the underlying may be delivered to their securities account. This is the case if the underlying touches the barrier during the term and is quoted below the strike on the valuation date. In the case of multi-structures, the "worst of" approach generally applies. If the barrier is breached, the redemption is based on the weakest underlying or the worst performer is booked to the investor's securities account.
The following new issues from Leonteq allow us to transfer the knowledge we have now acquired in theory into practice. First we look at the Reverse Convertibles. A single RC on Nestlé and a multi RC on Nestlé, Novartis and Roche are in subscription. Maturity (3 years), currency (CHF) and strike price (100%) are the same for both products. The difference is noticeable in the coupon. While the Single RC provides a quarterly interest payment of 5.40% p.a., the Multi brings 8.00% p.a.. This clearly shows that higher coupons are possible with more underlyings, as several equity risks are bundled here.
Furthermore, Leonteq has three Barrier Reverse Convertibles on the three SMI heavyweights Nestlé, Novartis and Roche. For this trio, too, the parameters of the basic features are identical: maturity (3 years), currency (CHF), strike price (100%), barrier (75%) and a worst-of principle. However, there are clear differences in the amount of the coupons. The classic Multi BRC has a coupon of 6.8% p.a., while the one with the autocallable function offers a maximum profit opportunity of 7.2% p.a.. With the second version, investors are compensated for the uncertainty about the actual end of the product's term with a higher interest rate, so to speak. The likelihood of early redemption increases with callable structures if the underlyings increase sharply or volatility decreases sustainably. The coupon on the soft callable BRC on Nestlé, Novartis and Roche is even higher at 7.5% p.a., because here the issuer has the right to choose whether the product actually expires before maturity on one of the observation days.
We look forward to answering all of your questions about our products and how they are traded. Please don't hesitate to get in touch! Phone: 058 800 11 11, email info@leonteq.com or contact us here.