In the early stages of the COVID pandemic in 2020 there was significant economic turmoil and a stockmarket crash. In the three years that have followed market volatility levels (both implied and historic definitions) have steadily dropped to the point where most measures are at very low levels.
Implied volatility is the more important for structured products as it reflects market pricing. There are many ways to assess the levels of implied volatility and different markets, geographic regions and asset classes do not move in lockstep.
Assessing volatility levels
A popular and convenient way to gauge volatility is the VIX Index which calculates the level of S&P-500 implied volatility. The VIX Index takes observed prices of exchange traded options and uses an accepted and transparent mathematical methodology developed thirty years ago. The headline VIX index is based on liquid very short dated (30-day) options. Although it is quoted less often, the 1 year and longest VIX measure (ticker: VIX1Y) is more stable and better representative of volatility levels that are relevant for short to medium term structured products.
The VIX1Y peaked in March 2020 at 40% and was still at 33% in October 2022 after the global concerns of conflict, inflation and interest rate rises last year. In the last nine months the index has fallen steadily and as of 28 July 2023 it stands at just over 20%. In contrast, the headline VIX peaked at 66% in March 2020 but now has fallen all the way to 13%.
This major structural shift in pricing conditions coupled with the rise in interest rates that has occurred in the same period has significant implications for issuing structured products and creates many new opportunities. We will examine two aspects of this new low volatility environment - the type of products that now look attractive and how to tactically play the secondary market.
Moving to lower volatility regime
For many years most markets had a regime of low interest rates and moderate to high volatility. This tended to encourage yield enhancing capital at risk solutions which would use the healthy premiums generating by taking downside risk (essentially selling a put option of some kind) to boost yield from the 1%-3% risk-free interest rate range to levels closer to 6%-10% expected and demanded by many investors.
Now that risk-free rates are around 5% and coupled with the extra pick up from taking bank credit risk there are income solutions that some investors are happy with that do not have any equity risk. The structured product sector has also seen good demand from issuer callable fixed income solutions where fixed icnome paid but with the issuer having the right to call (terminate) the product early, for example annually after 2 years on a 5 year product. This can enhance yield by up to 1% p.a. and to many investors seems like an almost irrelevant concession since it affects neither capital or income rates.
For those seeking more than the risk-free rate one increasingly popular approach is to offer for contingent equity linked income while retaining capital protection. An example of this is to pay a fixed coupon each year if an Equity Index is above its starting level. These types of strategies strike a good balance of risk and opportunity but have little volatility sensitivity and so do not benefit significantly from lower market volatility.
Decreasing volatility levels shift the opportunity back to growth solutions because the way to benefit is to buy options and income products have limited opportunity to do so. The most obvious solution to take advantage of low volatility would be a five to seven year capital protected product with full participation in equity growth. This would benefit from low option prices but would need strong equity growth to yield the best return. A more likely compromise therefore would be a capped participation product which boosts the equity exposure up to the cap level and would provide a higher return in the event of moderate equity growth. There is also a perception that equity markets are quite expensive, the S&P-500 for example sits at less than 5% from its all time high near the end of 2021 making capped products more logical.
Change of product type offerings
By contrast, lower volatility levels make the standard at risk equity linked products less attractive because the premium generated is much less. These include capital at risk Auto-calls which have dominated for many years. Such products are usually at least five years long and if volatility levels were to pick up again valuations would suffer in the secondary market.
However even for this type of products there are some benefits in lower volatility, for example barrier levels can be made more defensive, going down from perhaps 70% to 50% since this protection is now cheaper.
While lower volatility levels do represent a significant change in pricing conditions it is not clear that this will lead to a seismic shift in investor demand since the focus on yield remains very high for most investors.
Analysis of the secondary market also deserves attention. For most retail investors, relying on the secondary market except in times of need is not always economic because of the bid-offer spreads that can be charged. Listed products or those sold to a single end client such as a private bank give better opportunities to tactically play changes in pricing conditions because bid-offer spreads tend to be lower.
Capital protected growth products stand to benefit the most in the secondary market if volatility levels rise. In the event that markets perform reasonably in the early part of a product lifetime but volatility levels pick up it may be worthwhile to sell on the secondary market and get a return from both the delta effect (market performance) and from vega (volatility sensitivity). The overall rate of return for the product earned in the first year or two would be therefore quite attractive, particularly if the expectation is that markets have little further upside. Changes in interest rate levels will also influence any decision to sell early, a fall in interest rates would further boost secondary market values. Successful activity on the secondary market can be achieved but does require frequent and accurate monitoring and sufficiently strong product growth to overcome the initial bid-offer spread of the product.
Therefore we can deduce that the current low volatility environment will present interesting new opportunities in product issuance and secondary market activity.
A version of this article has also appeared on www.structuredretailproducts.com
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