A Hidden FANG Trade Is Rising Thanks to These Exotic Bonds

(Bloomberg) -- For those fretting the end of days for tech stocks on the heels of Netflix Inc.’s recent plunge, Wall Street might have just the product for you.

Meet FANG, in structured-note form.

Holders of these securities -- complex bonds tied to the performance of Facebook Inc., Amazon.com Inc., Netflix and Google parent Alphabet Inc. -- typically forgo the prospect of stratospheric upside. In return, they can weather as much as a halving in the cohort’s equity value, and along the way may accrue double-digit coupons and eventually their principal.

The popularity of these products is mounting. Investment banks have sold nearly $60 million of FANG-linked notes this year, up from $45 million over the same period in 2017, according to data compiled by Bloomberg, many of which are structured with such downside protection.

A Hidden FANG Trade Is Rising Thanks to These Exotic Bonds

As tech leaders report earnings in the coming weeks in a long-lived bull market, the products’ protective buffer may yield more appeal for retail investors seeking FANG exposure with a twist.

“It’s a bit late in the cycle, especially for these stocks,” said Guillaume Chatain, chief executive of structured-note platform ResonanceX and a former JPMorgan Chase & Co. banker. “Maybe you feel like you want to have some exposure but don’t feel like they’re going to be up 80 to 100 percent again. What you hope for is that all the stocks remain together and continue to move in sync.”

The quartet is responsible for over half of this year’s Nasdaq 100 gains. Long positions in the shares, as well as Baidu, Alibaba, and Tencent, are considered the most-crowded trades, according to Bank of America Merrill Lynch’s fund manager survey this month.

The options market has signaled some concern tech equity gains so far this year might cease, and investors are ready to punish stumbles. Netflix’s new-user miss sent shares of the video-streaming service down as much as 15 percent on Monday.

Tail Risk

A recent FANG note was sold by Royal Bank of Canada on June 27. The three-year securities pay an annual coupon of 10.2 percent as long as none of the stocks has fallen by more than 50 percent from its starting level on quarterly observation dates. At maturity, if the product hasn’t been called, holders regain their principal -- as long as none of the shares have fallen by more than a half.

The notes are in effect an exotic-derivatives strategy that involves selling down-and-in put options, a trade typically restricted to the most sophisticated investors. Holders face call and counterparty risk, thin liquidity compared with the underlying shares, and give up their right to collect dividends.

In exchange, they can gorge on coupons as high as 17 percent in the case of notes sold by Credit Suisse Group AG in April, with protection against a 40 percent swoon in any of the companies. Anything more than that and holders forgo interest payments and could lose as much as their entire principal.

Spokespeople at RBC Capital Markets and Credit Suisse, respectively, declined to comment on the notes.

A Hidden FANG Trade Is Rising Thanks to These Exotic Bonds

The chance that either Facebook, Amazon, or Alphabet will fall by 40 percent by January 2020 is 3 percent or less, according to delta-implied probabilities from put options. Netflix is seen as the most vulnerable at about 5 percent, according to data compiled by Bloomberg. That doesn’t take into account the chances that any one of the four stocks could fall by this amount, which is higher than any of the individual probabilities.

David Schawel, for one, isn’t a fan of FANG structured products. The chief investment officer at Family Management Corp. said holders of the notes are effectively "selling very inexpensive volatility."

"It’s not so much that they’ll definitely end up losing money, but they’re selling an underpriced tail option," he said.

Don’t forget: buyers also face correlation risk. Although the products offer downside protection, they’re in effect betting the stocks will continue to move together, said Chatain at ResonanceX.

“It’s an interesting product, but you need to understand where your risk is."

©2018 Bloomberg L.P.