Introduction
In a world of technological innovations, expecting phenomenal changes in finances or investments may not surprise most of you. You have a variety of trading or financial instruments to choose from. When you are spoilt for choices, things get more overwhelming. Isn’t that true?
Back there in the 1990s, investors had only two options to choose from. It was an equanimous choice between bonds and equity. Traditional bonds allowed investors to park their funds in Govt aided treasury bills, bonds, and mortgages. At the end of the tenure, investors were given a fixed rate of return along with the principal amount. And, the term of the bonds were scattered between 15-25 years.
And then came equity. Here, at stock exchanges, investors bought shares or stocks on the same day and sold them for profits the same day. The brokerage or fee was levied and the profit margins at the share market were volatile. However as there were lucrative returns on investment, the investors didn’t mind the volatility of equity markets and continued trading in shares or equities of leading firms.
Now, comes a third variety of investments that combine debt or bonds with equity. These hybrid investments are also known as structured products or structured notes. The notes have a debt component that safeguards an investor’s principal amount while the other portion of the note comprises a derivative component. You can link the note with debts like mortgage bonds or credit notes while assets can be in the form of stocks, shares, a basket of securities, indices, and currencies to name a few.
Investors can customize these notes according to their level of risk-tolerance which is why structured notes are gaining great popularity amongst the investing world.
You have equity-linked notes, autocallable yield notes, principal protection notes, and lot many varieties that fall under the category of structured notes or structured products.
In this blog, we are going to learn complete know-how on how auto-callable yield notes work. Shall we get started on the same?
Autocallable Yield Notes- Meaning And Conceptualization Explained
Auto callable yield notes are short-term investments wherein the notes are offered at above-market coupon rates.
The notes are initially offered at discounted purchase price values and the investor redeems them at their par market values. The difference between the purchase and sale points of these coupon bonds marks the profit margins or returns on investment for the investors.
Product issuers of autocallable notes do not wait for specific maturity dates to redeem the notes amongst investors. The notes are auto-called and these dates can fall before the actual maturity dates of the notes. That primarily explains why these notes are also known as autocallable notes.
The notes are auto-called when the underlying assets of the notes remain at par or go above the initial strike prices at given observation dates. In other words, if the referenced asset is at or above the initial values at pre-determined observation dates, the auto-call options can be triggered by product issuers.
The notes can then mature and the entire value of the notes can be redeemed by investors at once. When the autocalls are triggered successfully, the investor receives his/her initial principal investment and the above-market value coupons.
The auto-call triggers can be initiated quarterly, half-yearly, and annually and these notes mature once an autocall trigger gets initiated. If you have a look at it, the underlying asset of the notes can comprise commodity, equity, equity index, commodity index, or even a currency.
What Are The Primary Features Of Autocallable Yield Notes?
Let us have an overview of some of the primary features that are associated with auto callable yield notes. Helping you get started on the same:
Principal Protection
Auto callable yield notes primarily provide principal protection to investors and that is the most attractive part of owning this type of investment portfolio. Most investors get their principal amount camouflaged with contingent coupons as long as the underlying value of the asset does not fall below the downside barrier limits as preset on the notes.
You can witness the purchase value of the asset at the end of every business day and this is what is known as close-up monitoring of your downside risk. Or, you can gauge the underlying value of the assets when the notes are about to mature just as in a typical European style of monitoring.
However, when the price of the underlying asset is below the barrier level and the notes have not been auto-called on any of the observation dates, then the investor is fully exposed to the decline of the underlying asset versus its initial value.
Enhanced Yield
The auto-callable notes provide enhanced yields as compared to traditional forms of investments. These are fixed-income bonds that are issued by prominent firms that boast of higher credit ratings and come to you with fixed maturity dates.
This is because the autocallable coupons are structured in such a way that the amount doubles every time an autocall trigger is initiated. For instance, if the coupon generates an ‘X’ amount of income for a given observation date, then it can double the next time a trigger is initiated.
In other words, upon the next auto call, the coupons generate ‘Y’ income that is 2 times X or 2X. The only specification here is that the underlying value of the asset must be at par or above the pre-determined level on said observation date.
It is to be noted that the maximum returns for investors are restricted to the payment of coupons alone and the investors cannot participate in further gains the asset earns.
For Whom Are Autocallable Notes Most Suitable?
The autocallable notes are most suitable for those investors who:
- aim for better returns on investments over traditional bonds or mortgages
- can forgo a part of or the entire principal amount
- are looking to diversify their investing portfolio and
- above all, have a thorough knowledge of how investments work
Important Considerations For Investors To Keep In Mind Before Investing In Autocallable Notes
These are the important considerations investors must keep track of when they decide to invest with autocallable notes. Let us see the pointers here:
Minimum Capital To Start With
The auto callable notes are affordable to middle-class retail investors. This is because the notes can be purchased for $1000 each. You can add increments of $1000 each post your initial investment.
High Coupon Yields
The exposure the investors have for autocallable notes can be wide and dynamic indeed. For taking on the risk tolerance of losing capital, the investors can be rewarded with higher coupon payouts after all. Investors earn better yields over traditional bonds or mortgages with similar credit ratings and maturity periods.
Short To Medium Term Investments
These are short-term to medium-term investment plans ranging from 1 to 3 years. Therefore, investors can get their capital investments and coupon payouts faster by adding to their dispensable sources of income.
High Credit Rating
The autocallable notes are typically issued by banks that are investment grade and have top-rated credit ratings.
Non-principal Protected And Contingent Downside Protection
The notes are not 100% principal protected as their values can diminish if underlying stocks or assets do not show elevated levels during observation dates.
However, the presence of downside protection sounds feasible to investors and it is the preset barrier levels that protect investors from getting unprecendeted losses from trade transactions.
What Are The Risk Factors Of Autocallable Yield Notes?
There are pertinent risk factors connected with investing in autocallable yield notes. Let us see what the risk factors are:
Risk Of Capital Erosion
Investors may lose the partial or entire value of initial investments depending on how the underlying assets perform in the secondary markets.
Limited Returns On Investment
Although autocallable notes promise better yields over traditional bonds or mortgages, the returns on investment still can appear on a lower scale to investors who may also want to have a direct investment plan concerning underlying assets.
As the notes are linked to assets, the investors receive coupon payouts alone and they cannot claim extra dividends or interest earnings if the underlying assets outperform in the markets.
Lower Range Of Liquidity
Investors may not be able to dispose of auto callable yield notes on account of the lower range of liquidity the product holds. These notes have to be retained by investors until they mature.
On the contrary, if investors want to sell the notes in the secondary market, factors like interest downswings, volatility, marketability, and other factors impacting underlying securities can have a bearing on the return of capital on the investment.
Creditworthiness Of The Product Issuer
Issuance of notes is done by product issuing firms like investment bankers and major banking corporations. However, the investor must carefully evaluate the creditworthiness of the product issuers for payment of capital investment and interest earnings. Therefore, the creditworthiness of the issuer plays a predominant role in the return of initial level capital investment to investors.
Tax Implications
You may have varied tax implications concerning how the income is treated on return of capital and coupon payouts that investors receive from the notes. It is always better you consult a tax advisor before putting your foot forward concerning this particular investment plan. You must understand what products offer lower taxes and this exercise must be done prior to maturity of autocallable notes.
The Bottom Line
Auto callable yield notes are suitable for investors who predetermine their risk tolerance before they begin to invest. As these are structured notes that combine debt with equity, you may receive downside protection against capital erosion. However, the upside potential or gains you receive from the aforesaid plan purely depend on how the underlying assets perform in the secondary market under pre-set or predesigned conditions.
The creditworthiness of product issuing firms also plays a major role concerning investors getting their principal amount and earnings back.
What are your thoughts on this? Do let us know in the comments!
