Introducing 'Auto-Callable Notes': Wall Street's Latest Scheme To Rip Off Retail Investors

It's a classic Wall Street bait-and-switch.

Despite the obvious flaws inherent in certain structured products targeted at retail investors - flaws that would become readily apparent to unsuspecting mom-and-pops if they only bothered to scrutinize the fine print instead of blindly trusting their financial advisor - the big wirehouses rarely miss an opportunity to seduce customers with high advertised yields, masking the fact that buyers are virtually guaranteed to pay more in fees than they earn in returns.

The Wall Street Journal highlighted the latest display of this predatory behavior in a story published Tuesday about the latest popular investment trend: "auto-callable notes" tied to the FANG stocks. The notes promise investors a sizable yield, but they can also be "auto-called" - i.e. the note is cancelled and investors are handed back their principle (minus a generous slug of fees) - should the underlying stocks outperform or underperform (the details vary from offering to offering). These note were supposed to help retirees and other retail investors reap any rewards associated with the stocks continuing their record run, while shielding them from the inevitable denouement. Or at least that's what they were told by their financial advisors.

Amazon

In reality, the bonds were almost always called before the end of their (often one-year) terms. In fact, many of the bonds issued during the first quarter of 2018 didn't make it to the second half, leaving investors with a tiny fraction of the advertised yield - and a mountain of fees that often eclipsed their advertised yield.

In the first quarter of 2018, banks issued 275 FANG-linked auto-callable notes, totaling $499 million, according to mtn-i. By the end of August, 74% of them, or $326 million, had been redeemed, the Journal found, delivering fractions of the full-year coupons. They have paid 3.2% of their purchase price on average. Bank disclosures on these notes’ estimated initial values indicate fees and other costs totaled an average of 3.4%, according to the Journal’s analysis.

Here's more from WSJ's Ben Eisen:

The notes are often sold to mom-and-pop investors seeking higher-yielding alternatives to government debt, which is reliably safe. Offering documents say that buyers can earn fixed payouts of as much as 25% of the purchase price annually without taking on the risk of outright common-share ownership.

Yet many of these FANG-linked notes fail to produce returns anywhere near that stated range, according to an analysis of securities filings by The Wall Street Journal. Many times, the upfront fees banks collected were higher than the total returns earned by investors.

That is partly because the notes—dubbed "auto-callable" because a rise in the stock price contractually triggers their redemption—are often redeemed in less than a year, and sometimes in as little as a month. In many cases the auto-callable provision leads investors to earn scant returns and receive their money back long before the stated term of the investment.

And according to mtni, a London-based research shop, issuance of these products has doubled in the last year, as several bulge-bracket banks, including Citigroup, UBS and the Royal Bank of Canada have marketed issues of these auto-callable notes for the FANG stocks.

"These products give these great teaser yields, and I think people have been drawn to it," Mr. Halpern said. Then, many of "these things will be called after the first quarter."

The lure of these products is a testament to the craze surrounding the market's most successful stocks, which have been responsible for practically all of the benchmark's gains so far this year. But the notes come with huge risks attached - if the underlying stocks underperform too dramatically, investors can lose some or all of their principle along with the fees - with relatively little in the way of upside (the recent string of FANG losses may have produced some anxiety for some well-meaning investors).

Among called notes linked to just one stock, the underlying shares rose an average of 18% between the time the notes were issued and the time they were redeemed.

The popularity of these types of structured notes attests to the powerful lure of technology stocks, which have risen sharply in recent years. In 2018, Netflix is up 82%, Amazon is up 66% and Alphabet is up 12%, compared with a 4.6% rise in the Dow Jones Industrial Average.

But the notes are unlike common shares, which offer purchasers unlimited potential gains as well as the risk of total loss. They are also unlike U.S. Treasurys, which pay out periodic “coupons” and entitle holders to full repayment at maturity.

Instead, the notes offer gains up to a certain, specified threshold and protect against only certain, specified equity losses. Typically, if the linked stock or basket of stocks trades below a designated barrier—say, 75% of its initial value—when the notes mature, investors can lose a share of their principal on par with losses on the stock or basket.

One issue of auto-callables tied to Netflix carried a yield of 20+%, but after Netflix shares climbed 6% in a month, the notes were recalled, leaving investors with a coupon payment of 1.7%, 100 basis points less than the 2.7% in fees that were paid upon purchase. Some experienced asset managers say auto-callables can be helpful for managing risk when they're tied to an index - but single-stock plays are too risky for most experienced investors to touch.

Which begs the question: How are financial advisors - who have a fiduciary interest to act in their clients' best interest - allowed to sell these things with impunity?