Auto Callable Contingent Interest Notes linked to Indexes

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MrDogg
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Auto Callable Contingent Interest Notes linked to Indexes

Postby MrDogg » Wed Aug 10, 2016 2:48 pm

Does anyone have knowledge or experience with Auto Callable Contingent Interest Notes?

My Credit Union Financial Advisor is trying to steer me into a 15 Month Auto Callable Contingent Interest Note linked to the S&P 500 and Russell 2000 Indexes offered by J.P. Morgan. If neither index drops below 30% of its current value during the term I get a minimum 6.5% interest (8.0% if it goes to full maturity) although, statistically, the notes are called at the 9 month point for 6.5% annual rate. If the indexes drop below 30% I don't get any interest and my principle is reduced. Minimum investment is $1000. Statistically the indexes only dropped below 30% in 2008.

My situation:
I have some extra savings beyond my Emergency Fund needs and am always wrestling with where to put them, e.g., into my Vanguard taxable 3-Fund Portfolio or Short Term Investment Grade Bonds or Bank/Credit Union CD's. I consider the funds as short term savings that I don't want to put at too much risk, I just want to get interest above the standard savings account rates.

Valuethinker
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Re: Auto Callable Contingent Interest Notes linked to Indexes

Postby Valuethinker » Wed Aug 10, 2016 3:03 pm

Whenever I look at these things they look horrible for investors. Lots of ways to not get what was promised.

There have been discussions down the years here, structured notes etc. Consensus is usually against them.

Just alter your bond-equity ratios to get the portfolio exposure upside/ downside you want.

RobertB
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Re: Auto Callable Contingent Interest Notes linked to Indexes

Postby RobertB » Wed Aug 10, 2016 3:16 pm

JP Morgan designed this instrument knowing that they were going to be on the issuer side of the bet. Do you think you are savvier than the team of quants that designed this note? Do you think JPM just didn't care about making money on this product? View this like a table game at a casino. You don't need to run the math to conclude that the house has an edge, you can just infer it from the fact that they're running the game.

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David Jay
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Re: Auto Callable Contingent Interest Notes linked to Indexes

Postby David Jay » Wed Aug 10, 2016 3:25 pm

MrDogg wrote:My Credit Union Financial Advisor is trying to steer me into a 15 Month Auto Callable Contingent Interest Note linked to the S&P 500 and Russell 2000 Indexes offered by J.P. Morgan.


Did you ask him what the commissions are on the purchase?

Like WCI says about Universal Life and Variable Annuities: "These products are designed to be sold"
"Prediction is very difficult, especially about the future" Niels Bohr

MrDogg
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Re: Auto Callable Contingent Interest Notes linked to Indexes

Postby MrDogg » Wed Aug 10, 2016 3:35 pm

Thanks guys, that's great advise.

It sounded a little too good to be true when the FA implied that the 6.5% was almost guaranteed.

I can handle some risk and understand volatility but really don't want to "gamble". Based on this feedback I'm going to invest it in my 3-Fund Portfolio maintaining my planned AA splits. By the way, I'm 72, retired and capital preservation is high on my list.

capgain
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Re: Auto Callable Contingent Interest Notes linked to Indexes

Postby capgain » Wed Aug 10, 2016 3:41 pm

Just run, don't touch this thing. Nice in concept, but many reasons to avoid. I used to work in this area.

Besides that, I'm a longtime reader who has decided to start posting (and asking questions!).

MrDogg
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Re: Auto Callable Contingent Interest Notes linked to Indexes

Postby MrDogg » Thu Aug 11, 2016 11:05 am

capgain wrote:Just run, don't touch this thing. Nice in concept, but many reasons to avoid. I used to work in this area.

Besides that, I'm a longtime reader who has decided to start posting (and asking questions!).


I have already decided not to invest in this but from a learning standpoint I am curious as to what the caveats are ("many reasons to avoid"). Can you as someone who worked in this area or someone knowledgeable with this concept explain or deconstruct it. Are there hidden fees? undisclosed commissions? Cases where you do not receive the minimum 6.5% rate even though the indexes were not triggered by a 30% drop?

I have to admit the salesperson presented a 'to good to be true' explanation and on the surface was rather compelling.

alfaspider
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Re: Auto Callable Contingent Interest Notes linked to Indexes

Postby alfaspider » Thu Aug 11, 2016 11:29 am

Good rule of thumb: If it's a financial product, and you learned about it from someone other than a neutral third party, you don't want it.

talzara
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Re: Auto Callable Contingent Interest Notes linked to Indexes

Postby talzara » Thu Aug 11, 2016 12:25 pm

MrDogg wrote:I have already decided not to invest in this but from a learning standpoint I am curious as to what the caveats are ("many reasons to avoid"). Can you as someone who worked in this area or someone knowledgeable with this concept explain or deconstruct it. Are there hidden fees? undisclosed commissions? Cases where you do not receive the minimum 6.5% rate even though the indexes were not triggered by a 30% drop?


You will get everything they promise you'll get. That's what makes structured notes so dangerous!

You've just asked about all the caveats you could think of. You completely ignored the fact that 6.5% is much too low of a return for the risk that you're taking on. Structured notes take advantage of the fact that the perceived risk is lower than the actual risk.

A structured note is simply a bond stapled to a bunch of derivatives. Your auto-callable contingent interest note consists of:

  • Selling a call at the money,.
  • Selling a put at 30% out of the money.
  • Selling a binary put at 30% out of the money.
  • Buying a bond with the proceeds.
  • All of the options are "worst of two" options linked to the S&P 500 and the Russell 2000.

This is a very, very risky product:

  • The loss only kicks in at 30%, but you take the full loss to principal. If the market falls 31%, you don't lose 1% -- you lose 31%.
  • The options are "worst of two" options, so your loss will be determined by the more volatile index. The Russell 2000 has a beta of 1.22, so the loss kicks in when the market falls 24.5% -- not when the market falls 30%.
  • You lose the full 6.5% premium if the market falls 24.5%. So your loss is actually 36.5% -- almost 1.5 times the actual market drop.
  • You give up all of the market gains.

Banks love structured products because they can hide the fee in the "interest" rate. They are actually taking a huge cut of the options premium:


That 6.5% "interest" rate that attracted you to the product? You're taking on so much risk that you should be getting paid a 11-13% options premium for it. However, the bank only gives you 6.5%. They're keeping the other 4.5% - 6.5%.

Nobody should ever buy structured products. If you want safety, then they're too risky for you. If you want to gamble, then they're too expensive for you.

larryswedroe
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Re: Auto Callable Contingent Interest Notes linked to Indexes

Postby larryswedroe » Thu Aug 11, 2016 12:56 pm

Fwiw

I have reviewed over 100 structured notes over the years and NEVER once found one that made any sense.

If interested in learning about them can read the chapter in my book on Alternative Investments.

But here's the simply short answer and all you need to know.
A) the job of the CFO of a financial institution is to raise capital at the lowest cost.
B) if the lowest cost is straight debt they will always favor it because it's cheapest to issue.
C) Thus if you are offered anything else you know you are getting a lower rate of EXPECTED risk adjusted return or the issuer would not offer it.
Very simple.

I have written many blogs on the research on these type products and typically they are overpriced by 3-6%, meaning you are being screwed. IMO these products should be made illegal (and I'm a libertarian). They have not only no social value, but they are destructive of value, simply transferring wealth from retail (dumb) money to their pockets. It happens because the products are opaque and investors don't know how to value the embedded options.

next time someone tries to sell them to you ask them to show you the purchase ticket with their name, or that of their parents on it. You'll never see it. And then RUN and never do business with them.

Hope that helps
Larry

jdb
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Re: Auto Callable Contingent Interest Notes linked to Indexes

Postby jdb » Thu Aug 11, 2016 2:26 pm

larryswedroe wrote:Fwiw

I have reviewed over 100 structured notes over the years and NEVER once found one that made any sense.

If interested in learning about them can read the chapter in my book on Alternative Investments.

But here's the simply short answer and all you need to know.
A) the job of the CFO of a financial institution is to raise capital at the lowest cost.
B) if the lowest cost is straight debt they will always favor it because it's cheapest to issue.
C) Thus if you are offered anything else you know you are getting a lower rate of EXPECTED risk adjusted return or the issuer would not offer it.
Very simple.

I have written many blogs on the research on these type products and typically they are overpriced by 3-6%, meaning you are being screwed. IMO these products should be made illegal (and I'm a libertarian). They have not only no social value, but they are destructive of value, simply transferring wealth from retail (dumb) money to their pockets. It happens because the products are opaque and investors don't know how to value the embedded options.

next time someone tries to sell them to you ask them to show you the purchase ticket with their name, or that of their parents on it. You'll never see it. And then RUN and never do business with them.

Hope that helps
Larry

This response is so good it should be copied to the Wiki page for posterity under Structured Notes. Only have one thing to add. During my ten years as trustee of business pension plan in which our advisor was Wall Street firm we were pitched on these structured products on a regular basis. And coincidentally the sponsor of these products was always the same firm which was acting as our advisor. Though we never took the bait, I was strongly opposed, my suspicion is that many pension funds have these products hidden in their portfolio to the benefit of the pension advisors who get large commissions.

MrDogg
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Location: South Florida

Re: Auto Callable Contingent Interest Notes linked to Indexes

Postby MrDogg » Thu Aug 11, 2016 2:46 pm

To talzara and larryswedroe:

Thank you so much. Your responses cleared it up for me. I sure didn't know the right questions to ask and I am very impressed with your understandings and explanations. Thanks again!

alfaspider
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Re: Auto Callable Contingent Interest Notes linked to Indexes

Postby alfaspider » Thu Aug 11, 2016 2:59 pm

jdb wrote:
next time someone tries to sell them to you ask them to show you the purchase ticket with their name, or that of their parents on it. You'll never see it. And then RUN and never do business with them.

Hope that helps
Larry


This response is so good it should be copied to the Wiki page for posterity under Structured Notes.


Agreed.

Though I'd be willing to wager even most of the salesmen don't really understand how these things work. They just know a few talking points and that they get a big commission if they can sell them.

jdb
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Re: Auto Callable Contingent Interest Notes linked to Indexes

Postby jdb » Thu Aug 11, 2016 3:35 pm

alfaspider wrote:
Though I'd be willing to wager even most of the salesmen don't really understand how these things work. They just know a few talking points and that they get a big commission if they can sell them.
[/quote]
Agreed.
To quote the definition of Structured Product in my favorite dictionary, The Devil's Financial Dictionary by Jason Zweig, " Investment Products structured to be profitable to the firms that sell them and incomprehensible to the clients who buy them".

cestan
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Re: Auto Callable Contingent Interest Notes linked to Indexes

Postby cestan » Thu Aug 11, 2016 3:54 pm

i was offered something similar by bbva representative. i think it came from merrill lynch and was based on four stocks but the same idea. i could not understand it so never bought it. it was pitched to me as almost guaranteed 9-10 percent return just like a bond. glad i said no

capgain
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Re: Auto Callable Contingent Interest Notes linked to Indexes

Postby capgain » Thu Aug 11, 2016 4:08 pm

Apologies for not responding sooner, but talzara's post explains it. In fact, the second of the two links has the key piece of information that banks obscure or don't disclose. If you click the slcg.com document, on the left side of the page it identifies the "fair value" of the product ~ $940, but you pay $1,000.

Structured notes are a combination of a zero coupon bond and options that achieve the stated payout. The bank makes money pricing the zero coupon bond too cheap and marking up the option. The fair value of the whole package will always be less than the per security cost -- usually by 2 to 8%, usually commensurate with the time to maturity.

As the capper, you take the credit risk of the issuing bank, just ask the folks holding the Lehman products how they did.

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RyeWhiskey
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Re: Auto Callable Contingent Interest Notes linked to Indexes

Postby RyeWhiskey » Thu Aug 11, 2016 4:23 pm

It's threads like these that make this forum so valuable. I had (and still have for the most part) no idea what an 'auto callable contingent interest note" is. But now I know that the fact that I didn't understand what it meant in the first place was enough to steer me clear, and if in doubt, ask. :beer
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