UBS' trigger phoenix autocallables linked to biotech ETF offer high yield but equity-like risk

By Emma Trincal

New York, May 13 - UBS AG, London Branch's upcoming trigger phoenix autocallable optimization securities due May 20, 2016 linked to the iShares Nasdaq Biotechnology exchange-traded fund give investors a high-single-digit contingent coupon, but the downside risk is compounded by the exposure to a highly volatile fund, sources said.

As a result, this type of investment designed for yield may be suitable for only a few, they said.

If the fund closes at or above the trigger price, 75% of the initial price, on a quarterly observation date, the issuer will pay a contingent coupon for that quarter at a rate of 8% to 9.5% per year. Otherwise, no coupon will be paid that quarter. The exact coupon will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the fund closes at or above the initial price on any quarterly observation date, the notes will be called at par plus the contingent coupon.

If the notes are not called and the fund finishes at or above the trigger price, the payout at maturity will be par plus the contingent coupon. Otherwise, investors will be exposed to the price decline from the initial price.

Tom Balcom, founder of 1650 Wealth Management, said that the yield is appealing but that allocating the notes to the right bucket might be challenging because the product is not the perfect fit for a fixed-income investor or an equity investor.

"Assuming the price is up from 75% of the initial level, you're getting about 2% to 2.35% income for that quarter. That's attractive," he said.

Two factors helped to reduce risk, he noted: the fund's current valuation and the type of barrier used for the principal repayment.

Some pros

"The current price is encouraging. At $231.00 a share, the ETF is down about 16% from its most recent high in late February when it peaked at $275.40. So it provides you with some cushion," he said.

"Another positive aspect is the European option. The repayment of principal is calculated point-to-point. I like that. You could have a dip between the beginning and the end and still have time to recover."

On the other hand, the barrier could be breached easily, he noted, given the volatility of the underlying ETF. The fund has an implied volatility of 30% versus 10% for the S&P 500.

"If you're looking for income, this 8% or 9% per year is not a bad yield," he said.

"Compare it to the risk-free rate, the 10-year [Treasury] is 2.6% ... obviously you have an investment designed for yield.

"The question is, are you comfortable with the exposure to equity, in particular a sector that is so volatile?

"Two percent per quarter is a pretty high yield, but the risk is there.

"If the index is down 30%, you're not going to care that much about the yield."

Not fixed income

The choice of a volatile underlying for income products such as autocallables or reverse convertibles is part of the trade-off. Because those structures sell volatility, the greater the volatility, the higher the premium delivered as a coupon to the investor, he explained.

"Obviously, they had to pick a volatile asset class in order to be able to provide that type of coupon," he said.

"If the client is bullish on the sector and wants a fixed return without having the swings of the index, that deal would make sense."

Still, Balcom said that it might be difficult to find the right client for this product or even for autocallable notes in general. That's because they offer a limited upside with an unlimited downside, hence providing less appeal for fixed-income and equity investors alike.

"You basically generate high income from market risk. The risk-on is what gives you the high coupon. Here's the problem though: typically, investors looking for income are not suitable for risk. There is a good probability of breaching the barrier, so you would never want to use that as fixed-income replacement," he said.

Equity replacement only

"It could be used as equity replacement because of the risk involved here. But you have to be comfortable with the low return. As an equity investor taking on equity risk, you may not want to see your upside capped at 8%," he said.

The iShares Nasdaq Biotechnology ETF was up 67% last year.

"I guess you would have to use it as an equity replacement and have a mildly bullish view on the sector. You would have to expect that the fund will go up but not that much so you can lock in some income along the way," he said.

But for all other types of investors, such as very bullish, bearish and fixed-income investors, the use for the notes would be limited, he said.

"If you're really bullish, you want more upside," he said.

"If you're bearish, the downside protection may not be enough.

"And if you're a fixed-income investor, this note is not recommended because of the risk.

"You have to use it as an equity replacement and with limited expectations. You have to believe that the market will muddle through for the next two years"

Synthetic replication

A market participant said that the product does not offer a satisfying downside protection.

"It's similar to a reverse convertible, and it has the potential for hefty losses," he said.

"People look for it for income, but they don't grasp the downside risk. If the market turns, they'll realize, yes I sold them a put. It can be put to me if the market goes down.

"I love to have downside protection, but I don't really like the 75% barrier.

"I would want to have an absolute floor even if it's less. For instance, one to one down to 10% and after that, I am protected.

"In other words, I could take a loss up to 90% of the initial price and then get protected. One for one from par down to 90. That's how I would see it."

While these higher protection levels are not commonly seen in structured notes, especially shorter-dated notes, the protection could be created relatively easily "synthetically" using options, he said.

For instance, with the ETF currently trading at $231.00 per share ("at-the-money"), a January 2015 put option with a $205.00 strike on the ETF has a cost of $11.40, he said.

An option contract is for 100 shares. January 2015 is the expiration date of the contract.

"That's a 5% cost to protect yourself," he said.

An investor long this option would be protected from any loss starting at the price of $205.00, which is 11.25% lower than the current price, he noted.

No absolute floor

"They are doing something somewhat different here. I don't like it as much because I have no idea what my downside is," he said.

"The notes do not offer that type of floor.

"They're buying an at-the-money put to protect you below the initial price up to 75%. That's your first 25% of contingent protection. They're selling a put down 25%. That's when the coupon kicks in. And they're selling an at-the-money call because above par is when the issuer can automatically call your notes."

While investors can "definitely get nice income," he said that he does not like the risk-reward profile of the trade.

"This is a reverse convertible in another form. You do have unlimited downside. You may have protection on the first 25%, but after that, the protection is gone," he said.

"If you're getting this product for the income, you sort of think of it in your mental bucket as a fixed-income instrument, but it's not. Some people can be lured into taking the unlimited risk for the income. This type of strategy entails a great deal of risk."

UBS Financial Services Inc. and UBS Investment Bank are the underwriters.

The notes will price Friday and settle May 21.

The Cusip number is 90272X380.

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