Monday, January 28, 2013

Heads They Win, Tails You Lose

The shysters are at it again. Wall Street firms have been marketing bonds---traditionally a conservative investment--that have yields souped up by derivatives in Apple stock. These "equity-linked structured products" carry hidden risks that are manifested when Apple drops more than 20% (it has plunged nearly 40% since September). One example:
Consider the "trigger yield optimization notes" issued by UBS on Sept. 26. The face value of each note was set at $700.71, almost precisely Apple's closing price three days earlier. The one-year notes pay monthly interest at an 8.03% annual rate, or about eight times what the average short-term bond fund offered at the time, according to Morningstar.

The notes are structured to repay the full $700.71 when they mature this Sept. 26, with one big exception. If Apple's stock closes below $595.60 on Sept. 23, then investors don't get their original principal back. Instead, they get one share of Apple. But Apple hasn't closed above $595.60 since Halloween.

For investors to get all their money back, Apple's shares must climb 35%. As of now, investors would lose at least 30%, even after counting the income they will earn.
As the article notes, the loss isn't certain. If Apple gets back above $595.60 by September 26, 2013, the investor will recover his principal and keep his interest payments.

One may not feel too sorry for bond investors, who are supposed to be wealthy and financially sophisticated. But if they were indeed that knowledgeable, they could have put together the instrument themselves at much less cost.

Let's assume that you wanted to construct a high-yield investment in the amount of $450 (approximately today's closing price of Apple).

1) purchase a $450 one-year Treasury bill that yields 0.16% (72 cents).

2) sell a one-year Apple $405 put option for $30.35. The risk is that the put will be exercised if Apple drops more than 10% from $450, i.e., below $405, in one year.

January, 2014 Put prices on 1/28/2013.
If Apple closes above $405 in January, 2014, the put expires unexercised. The total income ($31.07) of the structure produces a yield of 6.9%.

If Apple falls, say, 20% to $360, then the loss on the deal, net of the income, is $360+$30.35+$.72 - $405 = $(13.93), which is (3.1%) of the investment.

Under the Wall Street structure, the investor receives one share of Apple instead of his principal; effectively, he is "put" Apple at $450, not $405 as in the self-constructed example. His loss would be $58.93, or (13.1%).

Obviously, the difference was pocketed by the structurer. Perhaps calling them shysters was being too kind. © 2013 Stephen Yuen

No comments: