Investment Banks Sell a Controversial Way to Hedge Volatility

(Bloomberg) -- As the shadow of volatility looms, it’s out with simplicity, in with complexity.

A little-watched corner of the investment-product industry is offering money managers some refuge from jittery markets by combining bonds with exotic options. The security offers juicy yields and the prospect of better returns than vanilla equity investments if prices swing moderately.

It’s a fresh approach for investors who have counted too heavily on passive instruments to gain exposure to stocks in recent years, according to UBS Group AG, which extols the virtues of the strategy.

The product’s moniker: the barrier reverse convertible. It’s an esoteric debt security issued by banks such as UBS which is linked to the performance of a stock or index, while protecting against modest declines in the underlying asset. As such, it’s effectively a hedge against an uptick in price swings for bullish investors.

While U.S. regulators have warned in the past about the risks posed by such products to retail investors, rising expectations that stock volatility will climb from 2017’s record lows are spurring money managers to hedge against price declines. That’s something they typically can’t do by holding merely long-only passive instruments.

“You want on the one hand to keep getting a relatively decent yield from your investments, but also protect your portfolio against short-term bouts of volatility -- and in fact make use of that volatility,” Maximilian Kunkel, chief investment officer for Germany at UBS Wealth Management, said in an interview. “Barrier reverse convertibles in a portfolio context help you achieve just that.”

Sales of structured obligations issued by banks in Switzerland climbed 32 percent in the first quarter from a year earlier to 92 billion Swiss francs ($91.8 billion), according to the country’s Structured Products Association. Notes like reverse convertibles made up 47 percent of those sales, many of which go to wealthy clients of Swiss private banks. The securities are also sold in Germany and the U.S.

The U.S. Financial Industry Regulatory Authority considers reverse convertibles to be complex products and has fined banks such as Wells Fargo in 2011 for unsuitable sales of the securities to elderly customers in America. In a separate bulletin that year, the regulator warned that “in exchange for these higher yields, investors in these products take on significantly greater risks."

Repricing Risk

The instruments are of a different stripe from VIX products, some of which blew up spectacularly in February. Here’s how it works: Owners of the notes effectively buy a bond and sell a put option on a stock or index, exposing them to losses if the equity sinks. Selling in this way gives them a higher yield than a vanilla corporate obligation.

The put is known as a “down and in” barrier option, which means it only kicks in when the stock falls beyond a certain amount, putting the seller on the hook for losses. If the stock falls less than that, stays steady or rises, the option is essentially dormant. This ‘barrier’ makes the securities less volatile than the underlying shares.

By allowing the referenced asset to move within a corridor, a portfolio with barrier reverse convertibles can deliver stronger risk-adjusted returns, according to UBS. It recommends six-month notes tied to individual stocks chosen based on a range of factors from implied volatility to analyst ratings.

“Our view is that you want to take out some of your long-only equity exposure and systematically deploy that capital in barrier reverse convertibles,” said Kunkel. Higher volatility and rising interest rates can improve the terms on the securities, he said.

Source: Bloomberg, Deutsche Bank, UBS, as of May 2018

The cost to investors? Fees are typically lower than for hedging strategies offered by active managers but higher than passive products. There’s also limited liquidity, and counterparty risk, or the chance that the issuer of the notes won’t be able to pay its obligation.

And as the appeal of such complex products grows for mom and pop, investors would do well to note it’s not a fool-proof strategy -- the built-in hedge crumbles once the barrier is breached.

“When the market is down a lot, that’s when your protection disappears,” said Guillaume Chatain, chief executive of structured-note platform ResonanceX and a former JPMorgan Chase & Co. banker.

To contact the reporter on this story: Yakob Peterseil in London at ypeterseil@bloomberg.net.

To contact the editors responsible for this story: Samuel Potter at spotter33@bloomberg.net, Sid Verma, Dan Wilchins

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