I was travelling last night, when I suddenly got an email from an old client, and Whatsapp from my niece highlighting I was quoted by Matt Levine of Money Stuff and Bloomberg fame. Matt was talking about a new issued autocallable ETF -and was quoting from a FT Alphaville article from 2022.

If you want to know more about autocallables, here is a link to my research on it. Matt does a good job of explaining it - basically you get a high yielding product and as long as you don’t have a deep recession of financial crisis, you will do fine. You are basically taking equity risk and credit risk for a yield pick up. I don’t like them as basically everyone that has ever issued them or been heavily involved with them as had huge problems with them. In recent years, Natixis was a big player, being involve heavily in the Korean market. Various losses weighed on its share price, until it was finally bought by BPCE (another French bank in 2021)

French banks loved structured products, and is one of the reason banks like BNP and Soc Gen struggle to trade above book in my view. Like all sort of insurance products, they have a long tail of contingent liabilities, which makes it difficult to know how to price these companies. If I thought markets were about to plunge, then banks like BNP and Soc Gen would make good shorts for this very reason. Could a bear market breakout? I have no idea - given the concentration of market into the Mag 7, and the increasing overlap in business caused by the AI boom, a price war, could or could not break out at any moment. Or maybe Big Tech work to keep pricing strong - who knows. But what I can do is tell you how autocallable markets are positioned so you know the risk to them if something does go wrong. I have found that markets are least risky when Koreans (the biggest players in the autocallable market) has seen net issuance collapse. That is currently not the case.

For reasons I explain elsewhere - for an autocallable market to exists you also need a dividend future market. Basically you want dividend futures to be rising as this is supportive of autocallables. S&P dividend futures have been sideways for 18 months.

Another way of looking at this is to take the dividend future and divide it by the S&P 500 to create a forward yield. This makes the S&P 500 looks unattractive in my view.

Finally autocallables are volatility selling products. I think they do best when long dated volatility is falling. UX8 which is generic 8 month VIX seems to be trending higher to me.

Autocallables are also credit products. Current credit spreads seem a touch low to me.

Finally, my last point on autocallables is that they make the cost of insurance (VIX) is this case artificially low, as investors become guaranteed sellers of volality. You can see this clearly with the Write Put Index - which is the return from selling puts on the S&P 500. Normally a good strategy, for the last 10 years, it has underperformed cash, due to VIX being structurally under-priced in my view.

If all of this is too complicated - don’t worry about it. It is all a long way of saying that we have not had a real US recession since 2008, so risk is basically priced like we will never have a recession again. I can see reasons for a why that may make sense, and why that is also totally crazy. If you are bullish, then buy the S&P 500 - playing around with autocallables seems like an expensive way to express bullishness - but then again I am a simple man that likes simple products.

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Nikkei volatlity has been extreme over the last 5 or 6 weeks.

As has Kospi volatility - the home of the autocallable market.

8 month VIX futures have inflected higher, which I normally see as a signal for increased volatility.

Are we potentially on the cusp of a volatility shock? Could the autocallable market finally unwind?

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I have been fascinated by “volatility” markets for years. Products that sell volatility to generate yield (or converting the premium you receive from selling volatility into a form of fixed income) - autocallables - have been an interest for me for years. Over the years we have seen various blow-ups in the volatlity markets - HSCEI in 2015/6, KOSPI in 2019. Back in GFC, Japanese autocallable products, particularly in currency markets proved to be totally disastrous. Most investors should remember the overnight implosion of XIV, a short VIX ETF, in 2018.

One of the things that I started to look at was trying to work out when volatility is “mispriced”. (This is a paid post - but I am offering a free trial to anyone that signs up to my other substack - www.jarrettclarkracing.com )

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I have written extensively about autocallables, so feel free to click on the tab on my home page. Historically, the main risk of autocallables is that they break through lower barriers, and leave the owners of autocallables out of pocket, and cause equity volatility to spike as structural sellers disappear. The biggest single market for autocallables is South Korea. They really took off when interests fell in 2010 onwards.

Historically issuance of autocallables has fallen after market weakness (market falls destroy capital, which takes awhile to rebuild). 2015 saw a sharp decline in issuance after problem with the HSCEI market that fell 40%, and then again after Covid. Recently issuance has slowed, rather than a sharp decline. I suspect one reason is that with BOK raising interest rats to 3.5%, the 5% typical yield on an autocallable in Korea is losing its lustre.

However reduced issuance does not mean that the amount of autocallables outstanding has fallen. In a typical down to sideways markets they just sit there waiting for markets to either break up or breakdown. If that does not happen then they will naturally expire in about 3 years time. However, the recent issues with Credit Suisse may change that.

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In a presentation on autocallables a few months ago, I stated that the hedging needs of autocallable structurers can create an environment where implied volatility can fall when the market falls, and conversely an environment where implied volatility rises as the market rises. HSCEI is giving a perfect example of the this “autocallable weirdness”. HSCEI has been very poor this year as the combination of a regulatory crackdown, zero covid and an aggressive Federal Reserve has seen the HSCEI fall to a low of 5000. But HSCEI has now rallied 27% in November, but VHSCEI has remained at distressed levels of 43.

For those of you blissfully unaware of how equity indices and implied volatility usually trade, I provide a graph of the S&P 500 and VIX over the same time period. S&P 500 has rallied 10% in November, and VIX has fallen from 31 to 22 over the same period. The logic behind this is that there is less demand for market insurance when markets rally.

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I have been talking about autocallables for a while and having looked at the weakness in markets this year, I had assumed we must be getting near some key barriers for the autocallable market. Experience has taught me 50% drawdown from a peak means you will be hitting an autocallable barrier. The main markets for autocallables are S&P 500, EuroStoxx 50, Kospi 200, Nikkei 225 and HSCEI. Of all of these markets, HSCEI has been the weakest.

In recent years, the HSCEI is the only market that has seen autocallables knock in, and that was in 2016, when the market fell 50% peak to trough. So I have been using peak to trough drawdown at that as a rough guide to where autocallable barriers are likely to be. On that basis, with the current drawdown from 2021 peak of 12,000 we should have passed some barriers. The fact is that market tends to very aware of where the barriers are, it’s just that this is not a data point that is shared widely. A friend passed me the latest estimates of where the large autocallable barriers for HSCEI. 5200 on the HSCEI is the key number for HSCEI barriers. This would put it at 50% down from the average level HSCEI traded over 2020, which is more than what I expected. That is I was using peak level, whereas using an average seems to work better.

Can HSCEI get to that barrier level? Well as long as the Chinese Yuan is weakening, I don’t see why not. With the Yen trading as weak as it is, I suspect it continue to pull Yuan down. Weak yen is actually bad for the markets.

This new information means that I need to assume barriers on the two biggest autocallable markets, EuroStoxx 50 and S&P 500 are also much lower than I assumed.

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There have been a number of questions and comments on autocallables. I will try and answer a few here.

My last estimate for the vega in the autocallable industry was a 700m USD from March 2019. Given that was before the covid crash, how big is that number now? Sadly I no longer have access to the team that produced that estimate. But when I look at the information sources that I do have access to, I am fairly sure vega has not dropped to much. First of all, Korean autocallable issuance very quickly recovered, which is unlike 2016, when issuance was subdued for a couple of years.

Why did Korean issuance recover so quickly? Well mainly because I don’t think many if any autocallables were knocked in.

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Whenever you ask bank or dealers about autocallables and its effect on implied volatility, the answer will be either -”it depends”, or a very long discussion about gamma and delta hedging. As I am not a options expert, I am going to give you my observations. Not all of this is provable, but it makes sense to me. The first thing you need to remember is that autocallables represent a liability to the bank. However each coupon payment and principal payment is a contingent liability, that is the payment of the coupon and principal will depend on the underlying movement in the index. Forgive my wonky graphic design work.

The problem with autocallables is that they are being constantly issued, and their knock in and knock out prices will vary according to where markets are currently pricing, and what sort of yield the investor wants. That makes working out where a big market barrier that might cause implied volatility to trade funny. However, we know three things about autocallables that help. First the knock in barrier tends not to be too far above recent all time highs. Secondly, typically nice round numbers are used as barriers. And thirdly, most autocallable structures are rolled over when they get called. Autocallable volume only declines when they get knocked in and investors lose capital. We can use these details to then examine the one market where autocallables were definitely knocked in - HSCEI in 2016.

HSCEI had been trading in a range between 9000 and 12500 since 2011. relatively high dividend yield and implied volatility made this a very popular market for Korean autocallables. VHSCEI tagged a very low level of 15 during 2014 when issuance was strong. In late 2015, the Chinese government announced a program to try and boost Chinese stocks, and the HSCEI suddenly broke out of its range to trade above 14000. My working assumption is that the most of all outstanding autocallables issued in the 2012 onwards would have been knocked out, and then restruck. You can see how VHSCEI actually rose when the 14000 barrier was passed, as suddenly a huge amount of principal moved back to retail, and needed to be repriced.

Given the very successful experience investing in HSCEI autocallables, and government support of the market, I suspect most knocked out autocallables were restruck at the 14000 level.

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Why have I started writing about autocallables? When I first researched them I realised they create very perverse market behaviour. One of the oddest things about them is that as autocallables approach a lower barrier, it can cause implied market volatility to FALL not rise as you would expect. Why? As an index gets closer to the barrier, the dealers and structurers need to hedge their exposure, and will be selling MORE protection which puts more pressure on the market price of volatility (ie implied volatility). If the autocallable breaks through the barrier, the risk transfers from the dealer to the investor, and suddenly volatility goes through the roof. So one warning sign I look for is an implied volatility that is at odds with market action. Korea is one such market, where the KOSPI 200 is down 27% from its peak, yet VKOSPI is pricing at 16.7 (pricing at close 13/9/2022).

When I look at HSCEI, a market that caused significant autocallable problems in 2015, volatility is also too low. The market is down 47% from its peak in early 2021, and yet VHSCEI is at 29, where a decline of this magnitude would normally see a VHSCEI of closer to 40.

The other area I have learnt to look at is dividend futures. The sell side will often claim that dividend futures are artificially depressed due to autocallable activity. My experience is that typically the dividend futures are correct, and when equity indices and dividend futures diverge, the index is incorrect.

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The autocallable market is a market born from low interest rates. Korea has become the mecca of equity linked autocallables. Korean issuance of autocallables began in earnest in 2012.

As short dated Korean bond yields, fell through 3% in 2012 issuance picked up. As a typical yield on a Korean autocallable is 5%, I wonder if the recent rise in yields above 3% could see autocallable issuance fall?

The short answer is that if autocallable issuance falls, then implied volatility will rise. Why? Autocallables are best understood as a distributed portfolio insurance market. What does that mean?

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To understand an autocallable or structured product does require some knowledge of the option market, as autocallables makes heavy use of derivatives. One of the classic strategies for hedge funds and portfolio managers have used to earn extra yield on a portfolio or even on a single stocks is to sell put options. Selling puts is in many ways like selling insurance. As long as you are selling at the right price, its a great business. You get the cash up front, and if nothing goes wrong you get to keep the cash. It is such a common strategy that CBOE has an index on the hypothetical returns of such a strategy. As you would expect, it underperforms in raging bull markets, such as from 2009 to 2021, but outperforms in sideways markets such as form 2000 to 2009.

The attraction of a Put Writing strategy is more apparent in Europe than the US, where the returns have been far higher, and generally speaking with far lower sell offs (ignoring the Covid bear market).

Autocallables offer high yields to investors through two main channels.

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During the just ended school holidays (halleluiah!) I had my family around to stay. Strangely, my father had never seen “The Big Short”, so after dinner we settled down to watch it. The underlying message of the little guy sticking it to the big guy is of course very satisfying, but even at the end of the Big Short, all the main characters accept the fact that bailouts were coming, and closed their positions. And ever since, buy the dip has been the correct strategy. I made decent money in shorting material stocks from 2011 through to 2016, but the big play underlying that was a potential Chinese Yuan devaluation, which has never materialised. I had assume China would be like South Korea, and see big devaluations when growth slowed. Instead the Chinese Yuan has stayed strong and stable.

Another area I did a lot of work on was clearinghouses. If clearinghouses had followed their own rules, then bankruptcy, or at least large equity raise from large banks were on the cards. In the end, clearinghouses just ignored their own rules to give de facto bailouts. I have many posts on it, so have a look yourself, but shareholders and clearinghouses have continued to prosper.

The US Federal Reserve really sets the tone for global monetary policy. And since 2018, one key commodity has been sending very deflationary signals in the US at least, and that is natural gas. But in 2022, that deflationary signal has well and truly ended. Note that the spike in 2001, coincided with the dot com bust, and 2008 spike coincided with the GFC. Prices this year, continue to surge.

This change in natural gas has made me think about “Big Short” style trades again.

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