Sales of Callable Stock-Tied Notes Soar on Markets as Risks Loom

U.S. investors are buying the most equity-tied structured notes that may be redeemed early, betting that stock values at an all-time high will keep rising.

Banks sold $8.62 billion of callable U.S. securities tied to stocks this year, 39 percent more than a year earlier and the most since at least January 2010, according to data compiled by Bloomberg. They issued a record $1.09 billion of the notes last month.

While the securities advertise coupons that can be more than four times higher than similar-maturity Treasuries (USGG10YR), investors face the risk of early redemptions if the stock performs well, or steep losses if it does poorly. The callable notes, some of which don’t mature for 20 years, may not pay any coupons over that time if shares drop too much, Bloomberg data show.

“The callables are able to provide headline yield by lowering the probability of actually attaining that yield through the maturity date of the note,” Joseph Halpern, chief executive officer of Exceed Investments LLC, which structures exchange-traded funds, said in a telephone interview from his office in New York.

Issuance of callable equity-linked notes, including so-called reverse convertibles, has more than doubled since 2010, when investors bought $4.4 billion of the securities, Bloomberg data show. Certain notes can be called at the discretion of the issuers, while others known as “auto-callables” have a pre-determined threshold that triggers an automatic redemption.

Early Redemptions

Banks have redeemed $3.46 billion, or more than 20 percent, of the securities that have been issued since January 2012, Bloomberg data show.

Bank of America Corp. (BAC) sold the largest such offering last year on Jan. 4, $97.1 million of two-year notes tied to the Standard & Poor’s 500 Index. (SPX) The securities were called in January this year, Bloomberg data show. The notes paid 10 percent, though could have returned 32.5 percent or more at maturity as long as the benchmark didn’t fall 10 percent from its initial value, according to a prospectus filed with the U.S. Securities and Exchange Commission.

Callable securities give a “huge advantage to the customer on day one, but they get a limited return,” said Halpern, who used to trade structured notes at banks including ING Groep NV and Toronto-Dominion Bank. “If it doesn’t get called, all of a sudden, it flips and becomes a huge advantage to the bank.”

No Coupons

UBS AG (UBSN) sold $2.75 million of five-year notes tied to the shares of Barrick Gold Corp. on July 19, 2012, that haven’t paid a monthly coupon since March, according to a prospectus filed the SEC and Bloomberg data. The company has tumbled 50 percent to $17.40 since the issuance date, making it less likely the securities will be called and boosting the chances that holders won’t get 9.5 percent in contingent yearly coupons and may lose at least 40 percent of their principal.

With callable notes, investors also face the possibility of losing attractive terms once the security is redeemed, known as reinvestment risk, said Tim Husson, a senior financial economist at Securities Litigation & Consulting Group.

A rising stock market has reduced the risk that investors will lose money. The Standard & Poor’s 500 Index, the most popular underlying stock index for structured notes, reached an all-time intraday high of 1,802.33 on Nov. 18. The S&P 500 has gained 25 percent this year, making it an attractive investment compared with alternatives such as 10-year Treasury bonds, whose yields touched a low in 2013 of 1.63 percent on May 2.

JPMorgan No. 1

JPMorgan Chase & Co. (JPM) leads issuers with $1.5 billion in sales of callable stock-tied notes in the U.S. this year, Bloomberg data show. Bank of America sold $229.8 million of auto-callable securities tied to the Euro Stoxx 50 Index on Oct. 24, the largest offering in 2013.

Justin Perras, a spokesman for JPMorgan, and Megan Stinson, of UBS, declined to comment on the notes. Susan McCabe, of Bank of America, didn’t return e-mails asking about their securities.

Bloomberg started to collect comprehensive data on structured notes in 2010. Banks create the products by packaging debt with derivatives to offer customized bets to retail investors while earning fees and raising money. Derivatives are contracts with values derived from stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.

Reverse convertibles, which typically mature in a year or less, pay a relatively high coupon, though investors can lose all of their principal if the company’s value falls to zero.

To contact the reporter on this story: Kevin Dugan in New York at kdugan4@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net

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