Master of the House and Sundae Sprinkles
Master of the House and Sundae Sprinkles
The Blind Squirrel's Monday Morning Notes, August 14th, 2023.
A whirlwind narrative arc takes us from Victor Hugo via “America’s angriest hedge fund” to principal protected notes. Bear with the 🐿️!
If you want downside protection with upside participation in the S&P 500 index, do it yourself! Introducing The Blind Squirrels ‘DIY’ option.
Today, structured products (and how they are hedged) are an important component of equity market structure and create yet another layer of market fragility. Ignore them at your peril.
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Podcast Edition:
Master of the House and Sundae Sprinkles
Family road trips in the 1980s required the use of a long-lost art. That of finding agreement between 2 adults and 2 teenagers on in-car audio entertainment (i.e., cassette selection!) To this day, I know every syllable of every song of the The Traveling Wilburys as well as the complete score of the blockbuster musical, Les Misérables.
The 🐿️’s late (and much missed) stepfather was in the restaurant business. As such, a firm favorite ‘Les Miz’ track was ‘Master of the House’. Monsieur Thénardier was the innkeeper who, in Victor Hugo’s original work, inadvertently saves the life of Marius’ father (while looting dead bodies in the immediate aftermath of the Battle of Waterloo). Of course, he was also the character that was memorably portrayed by ‘Ali G’ in the 2012 movie version of the epic.
Every word of the tune hits a button, but, in a truly acrobatic narrative segue, the following verse made me think about principal protected notes (PPNs) - we all have our problems (!)- as well as those who structure and sell them. This is our topic for today.
Charge 'em for the lice, extra for the mice
Two percent for looking in the mirror twice
Here a little slice, there a little cut
Three percent for sleeping with the window shut
When it comes to fixing prices
There are a lot of tricks I know
How it all increases, all them bits and pieces
Jesus! It's amazing how it grows!
Hear me out before your eyes glaze over. This is more than a cautionary tale about the hidden costs embedded within these products. Yes, we are going to review what ‘The Big Short'’s Jared Vennett memorably describes as the “sprinkles and cherry” on the sundae (CDS) being bought by “America’s angriest hedge fund”.
We are going to look at ways you might be able to keep most of the ‘sprinkles’ for yourself as well as review the impact of the renewed popularity of these structured notes on broader markets. It is much more significant than you might imagine.
Michael Ashton (aka ‘The Inflation Guy’) published a superb piece, entitled ‘How the Fed Saved Structured Note Issuance’ in his blog last month. In it, he observes that increases in interest rates and lower implied volatilities (for options over equity indices) have injected “new energy” into the private note structured product market.
He provides the simplest example of a PPN (most PPNs incorporate much more exotic payoffs (for ‘sprinkles enhancement’ reasons). This is of course red flag No.1. As Michael says, “from the standpoint of the dealer, the more exotic the better because the harder it will be for you to price it and the more profit, therefore, they can book on it”).
“I might issue a note that will pay you 60% of the total gain in the S&P 500 over the next 5 years – but if the S&P is lower in 5 years, you still get your money back.”
‘What witchcraft is this?’, I hear you cry. It’s actually pretty simple. Your private banker takes your money and reinvests 80% of it in (zero-coupon) Treasury “STRIPS”. With the balance of the funds, he is off to Goldman Sachs or Morgan Stanley to buy a long-dated S&P 500 / SPX call spread. He packages the 2 products together, puts a fancy name on it and, voila, you have your PPN.
The problem is that there are many mouths that need to be fed in its creation process. Your PPN may be advertised as “commission free”, but your private banker is going to be rewarded with a generous sales credit when you buy it. Then the plumbing needs to be paid for - those structurers and lawyers do not come for free. Then the note issuing bank needs to be compensated for the use of its balance sheet. Then the dealer writing the underlying equity call spread needs his bit of the action (they call it ‘edge’). You get the general idea…
Did I hear you say that your private banker just offered you principal protection with 60% of the upside in the S&P 500 for the next 5 years? Well, how about 90%?! Middlemen are expensive - you can keep the ‘Sprinkles and the cherry on the Sundae’ if you want to! I give you The Blind Squirrel ‘DIY’ (do-it-yourself) PPN (click the image below to watch the walk-through video).
Link to OptionStrat worksheet for the SPX Call Spread.
Link to OptionStrat worksheet for the (lower cost) SPY alternative.
Don’t worry, the Blind Squirrel Structured Products desk is not open for business. I am not going to sell you this note because it involves you becoming implicitly short the biggest option of all - cash liquidity. By all means buy the SPX call spread if you like the payoff profile. Just hold on to the other $400,000!
Duration risk is not extreme with 5-year STRIPs, and I do not want to digress into a debate on inflation and Fed hiking paths from here. However, I would be pretty relaxed about wearing your reinvestment risk for the next couple of years. We may be getting close to terminal rates (i.e., not many more (if any) interest rate hikes) but I see fewer near-term rate cuts than what is currently implied by interest rate (SOFR) futures market pricing.
Keep your money in T-Bills (earning 5.4%!) in readiness for bargain shopping when these ‘higher for longer’ rates start breaking things in asset markets.
OK so why am I talking about PPNs. I may be gently teasing private bankers about the expensive gear they are selling to their wealthy clients, but the important takeaway is that structured products are not a niche activity. Global issuance volumes in a post-GFC yield-starved world (they are often pitched as income products) have been enormous.
I have mentioned
in dispatches before. He has done a lot of work looking at Asian structured note issuance [paywalled site] in particular. Highly recommended.
Furthermore, the hedging activity around the issuance of these notes has a significant impact on the equity market structure that we interact with on a daily basis. Which brings me to Cem Karsan and his ‘lady-with-the-donut-inflatable’ meme.
Cem frequently (and generously) shares his knowledge on the equity volatility complex. He has been vocal on how structured product issuance has created a situation whereby volatility is currently (over)supplied in the market. This has the effect of dampening realized volatility in cash equity markets (attracting even greater equity allocations from ‘vol targeting’ funds!).
If you are not familiar with Cem’s work, watch him discuss this issue on Realvision a couple of weeks ago (watch him here with Maggie from minute 10 on the video).
This hedging flow, in combination with physics (the natural path for markets is up); corporate share buybacks; and 401(k) and other (largely passive) savings flows all have the effect of driving the main indices higher until the point at which an exogenous macro event ‘unpins’ that tinder box of volatility. That point is ‘buckle up’ time - think 2018’s ‘Volmageddon’ or the March 2020 ‘covid crash’.
Today, PPNs and structured products (and how they are hedged) are an important component of equity market structure and create yet another layer of market fragility. Ignore them at your peril. Also, if you are planning to buy long-term upside in the S&P 500, keep the ‘sprinkles and cherry’ for yourself. Monsieur Thénardier will be just fine.
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