S&P 500 Futures index seen as big underlying story of the year in structured products

By Emma Trincal

New York, Jan. 4 – One of the major stories this past year has been the growing use of the S&P 500 Futures index as an underlier in structured products, appearing for the first time in the second half of 2023.

The index measures the performance of the nearest maturing quarterly E-mini-S&P 500 futures contracts.

A total of $135 million has sold this past year in 50 deals versus none in previous years, according to data compiled by Prospect News.

“It’s one of the most interesting events of the year,” said a market participant.

“I’m taking the risk of rolling futures contracts. Essentially, I’m exposed to contango risk,” he said.

“You get a better structure for the potential of lagging the total return of the spot index.”

Contango

Futures contracts approaching expiration have to be replaced. The term contango means that the sale of the nearby contract will take place at a lower price than the price at which the distant delivery month must be purchased. Known as a negative roll yield, such cost will erode the value of the index.

Futures prices are based on the differential between interest rates and the index’s dividends. Higher rates often reflect inflation expectations and uncertainty, which lead longer-dated contracts to be more expensive than current prices.

“When interest rates are higher, contango is deeper,” said Steve Sosnick, Interactive Brokers’ chief strategist and head trader.

In the higher interest rate environment, issuers have began to tap into the pricing power of the newly employed index.

A drag

“With higher rates, you get better pricing on the forward. But there is no free lunch. You’re getting better terms as a compensation for the risk you take. And that risk is the uncertain path of interest rates and dividends relative to where the futures curve implies,” the market participant said.

The negative roll yield will cause the S&P 500 Futures index to underperform the spot index, said Brady Beals, director, sales and product origination at Luma Financial Technologies.

“The main goal of the structure if you have a conviction that rates will go down is to get you as much leverage to offset the drag on your performance caused by the futures.”

The market participant agreed: one may conceive the trade as a bet on lower interest rates.

“With rates where they are, the forward allows you to price much better terms based on the expectation that rates will come down at some point,” he said.

“You have to deal with the contango risk that affects forward prices here on the equity space.”

The spread between the spot price and futures will widen with lower dividends and higher interest rates, he explained.

Not mainstream

The level of complexity of those trades limits their use.

“I wouldn’t want to explain it to a client. You don’t want to bring a futures curve conversation into equity,” he said.

“But you don’t have to get into the math. The terms speak for themselves.”

Notes linked to this index are not for the average adviser, he said.

It’s for the more sophisticated channels, the more sophisticated clients,” he said.

Part of what is difficult to explain is how the underperforming index can give investors more compelling terms.

One of the answers is the leverage.

Structurers aim to use leverage to offset the differential in performance between the S&P 500 Futures and the spot index, hence, reducing the drag as much as possible.

Margin magic

An easier way to explain the advantage behind the futures index is margin.

That’s because futures trade on margin. The carry of the futures contract is the interest rate.

Treasury rates exceeding dividend yields generate a positive spread.

“Futures tend to have advantageous margin requirements, meaning that an investor can control a certain amount of a commodity while only using a small percentage of the money required to buy it when the futures contract expires. The money that is not utilized can be invested in risk-free assets, such as T-bills,” said Sosnick.

The futures contract is going to be worth more when interest rates are rising because of the margin, he added.

“If it cost me 1/10th of the cash position for instance, I can then take the difference in money and buy treasury bills.”

“I give up the S&P dividends, which is 1.55%. It's a little bit of a drag. But if I buy a one-year T-bill, I get 5% and I only have to forgo 1.55%. That's the advantage,” he said.

This advantage, or spread, is what allows issuers to offer better terms.

Some risks

With the spread, banks can also improve hedging.

“Issuers use this index as a hedge against dividend risk. When you hedge better, your cost is cheaper and your terms better,” a structurer said.

Issuers and investors face different risks.

For issuers, the risk is if rates start to trend downward, making the pricing of those notes no longer marketable.

For investors, a rise in interest rates would be the culprit.

“If rates continue to go up, you can get hurt. The drag versus the spot would increase. You’ve locked in a yield that may not compete with rising rates. You are exposed to interest rate risk,” said Ken Nuttall, chief investment officer at BlackDiamond Wealth Management.

This is one of the reasons many buysiders doing the trade keep it short, he added.

The direction of interest rates in this New Year will tell whether the trade was just a fluke or if it may thrive.

© 2015 Prospect News.
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