BNP notes on Morningstar Ultimate Stock-Pickers Vol 7 offer high leverage, principal-protection

By Emma Trincal

New York, Jan. 13 – BNP Paribas’ 0% notes due Jan. 26, 2028 linked to the Morningstar Ultimate Stock-Pickers Target Volatility 7 index use volatility control to maximize the upside leverage while still providing full downside protection and no cap on the upside.

The notes offer at maturity par plus 340% of the index return, subject to a minimum payout of par, according to a term sheet.

The index is based on investment managers selected by Morningstar that have outperformed the market for a number of years.

But low-volatility stocks and outperformance are not necessarily a recipe for high future returns, said Clemens Kownatzki, finance professor at Pepperdine University.

The index

The Morningstar Ultimate Stock-Pickers Target Volatility 7 index provides variable exposure to the Morningstar Ultimate Stock-Pickers index, or base index, according to the prospectus. The exposure to the base index is adjusted to maintain a target volatility of 7%.

The index encompasses the stocks which are the most widely held and most heavily purchased by the industry's top active managers. This index does not incorporate Environmental, Social, or Governance (ESG) criteria, according to Morningstar.

Consensus

“I don’t believe the index is giving you much of an alpha,” said Kownatzki based on the central concept of picking stocks that are the most heavily purchased and the most held by the selected managers.

“The more of a consensus you have, the closer you get to the average performance of the benchmark. If your idea is to outperform the market, this is not the way to go,” he said.

No guarantee

Morningstar gives priority to investment managers with a tenure of more than five years and a track record of beating the S&P 500 index. Other proprietary criteria such as “uncertainty ratings” and “conviction scores” are included as well. The number of investment managers for the index is 26.

Kownatzki was not impressed by the emphasis on track records.

“Historically, you always have a reversion to the mean. Studies show that there are very few managers that outperform the S&P over long periods of time.”

He pointed to the Semi-Annual S&P Indices Versus Active scorecard, known as SPIVA, which is a research report published by S&P Dow Jones used to measure the relative performance of active managers over the market.

“SPIVA has demonstrated how active managers underperform their benchmarks. About 80% of those managers underperform,” he said.

Exclusive rights

BNP Paribas has been using the Morningstar Ultimate Stock-Pickers Target Volatility 7 index as an underlying for structured products since the creation of the index in 2012 when it entered an exclusive license agreement with Morningstar. Bank of the West, an affiliate of BNP Paribas, has routinely issued the indexes as well for the issuance of market-linked certificates of deposits.

Five-year tenor

Kownatzki pointed to some factors facilitating the pricing of the notes.

“By using over-the-counter derivatives, the issuer is able to extend the expiration date further than exchange-traded options,” he said.

The maximum duration of exchange-traded options is two years through Long-term Equity AnticiPation Securities, or LEAPS.

“Going out five years cheapens the option on a relative value basis. The longer the time to expiration, the less of a time value cost on a relative basis or if you will on a per-day basis,” he said.

Cheap premium

But what really helped the pricing of the 3.4 times leverage multiple was the volatility control, he noted.

“The volatility target cheapens the cost of the call options that you buy to provide the leverage. When the implied volatility is lower, the premium is lower as well. Since low volatility is usually associated with lower risk, it’s going to effect the price of the option. In this case, the cost of buying the calls is less,” he said.

He offered a concrete example.

“A 20-year-old is going to pay a higher premium for his car insurance than a 40-year-old married woman would.

“When the risk behavior is greater, the cost of your premium increases as well.

“With a 7% volatility target, you can really increase your leverage, and 3.4 times is quite a lot of leverage,” he said.

The volatility is significantly reduced, he added. The 7% target is twice less than the 15% implied volatility of the S&P 500 index.

Since the call options are cheap, the issuer does not need to write call options (the equivalent of capping the upside) in order to finance the purchase of the calls, he noted.

Top holdings

Among the top 10 holdings are Bank of New York Mellon Corp., Aon plc, Air Products & Chemicals Inc., CVS Health Corp., McDonald's Corp. and Lockheed Martin Corp.

“If you’re targeting an overall implied volatility that’s low, the main components of the index will have a relatively low volatility as well. It’s really about the composition of your portfolio,” he said.

The top names have an implied volatility greater than that of the S&P 500 index. But their volatilities, which ranged from 20% to 30%, remained moderate for single stocks, he noted.

Interest rates

The principal-protection could be put in place thanks to the high level of interest rates rather than volatility, he said.

“We’re seeing more principal-protection now even over shorter tenors. Interest rates have not been that high in 10 or even 15 years. The zero coupons used for the principal protection now are trading at deep discounts, which you can use to buy the options,” he said.

BNP Paribas has a successful track record in selling structured products linked to the Morningstar Ultimate Stock-Pickers indexes despite the fact that financial advisers tend to avoid showing so-called smart beta or rules-based indexes due to their complexity.

Marketing

“The construction of the index is pretty involved. The prospectus describes in great details how the managers and securities are selected,” he said.

“But at the same time, I wouldn’t say it’s a black box. The strategy is genuine. I don’t question the integrity of the index.

“I just doubt that advisers are going to read the prospectus and explain the index to their clients. It’s just my skeptical, cynical bias.”

The principal-protection and the Morningstar brand were probably appealing enough by themselves to pique clients’ interest, he added.

“It’s most likely an easy note to sell. But it’s not a bad note. The vol. control may dampen your return. But at least your risk of losing money from the market is zero.

“I like it.”

BNP Paribas Securities Corp. is the agent.

The notes will price on Jan. 26 and settle on Jan. 31.

The Cusip number is 05592QYU3.

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