MARKETS ARE LULLING THEMSELVES INTO A FALSE SENSE OF SECURITY / THE WALL STREET JOURNAL

Markets Are Lulling Themselves Into a False Sense of Security

Stocks’ low volatility may be a misleading result of a boom in autocallables and other structured products

By Jon Sindreu

Goldman Sachs and other U.S. banks are big issuers of autocallables. PHOTO: PHOTO: ANGUS MORDANT/BLOOMBERG NEWS

If you bought so-called structured products recently, you have plenty of company. 

But it is precisely their popularity that could make them—and perhaps the entire stock market—riskier than they seem.

Originally a European specialty, these investment products are growing everywhere. 

Sales volumes in the U.S. were a record $132 billion in 2023, figures by analytics firm Structured Products Intelligence show, up from $78 billion in 2020.

The most widespread type are “autocallables,” which are particularly big in Asia. 

Sold by banks, the notes are linked to the price performance of an underlying asset, for example, the S&P 500. 

If the index is within a certain range on given dates, buyers receive generous coupons. 

If it goes above a threshold, the note gets repaid. 

Often, they offer some downside protection too. 

Investors lose stock-market upside in exchange for income and a bit of extra safety.

The bargain often appeals to less sophisticated savers who otherwise might not dabble in complex derivatives. 

During the era of near-zero rates, the products became an attractive alternative to time deposits and bonds, sometimes yielding as much as 10%.

For banks, they bring in fat fees. 

France’s BNP Paribas and Société Générale are well-known issuers, but JPMorgan, Goldman Sachs and Citi are even bigger players in terms of global market share.

The more recent surge in structured-product sales since central banks started tightening policy might seem surprising, given revived competition from deposit accounts and money-market funds. 

In part, this is because bonds also yield more now, and banks have been savvy in refocusing their derivatives desks to structure attractive notes around them.

But it is also because swings in the stock market have been subdued since late 2022. 

Equity-linked autocallables are essentially bets against volatility: Buyers want stocks to go up but not too much, and they certainly don’t want them to go down. 

The products share certain similarities with the “covered call” strategies of funds such as the Global X S&P 500 Covered Call ETF and the JPMorgan Equity Premium Income ETF, which have also experienced huge inflows since 2021.

It might seem strange that volatility is so low when inflation, monetary policy and geopolitical conflicts make the global economy more uncertain than ever. 

Here is the problem: Structured products might themselves be what is lowering it.

In its quarterly review published Monday, the Bank for International Settlements pointed out that the banks selling all these notes have been forced to take the other side of their clients’ bets. 

To hedge the risk, trading desks have been leaning against swings in stocks, selling them when they go up and buying large drops—a practice known as delta hedging. 

This has pulled down long-term volatility, making it cheaper to insure against it. 

In turn, this has resulted in a lower level for the widely tracked Cboe Volatility Index, or Vix.

So autocallables look attractive because the stock market is calm, but the market is calm because people are buying so many autocallables. 

This feedback loop is reminiscent of the one created by funds that directly wagered against volatility back in 2017 and 2018. 

When a bout of selling broke the cycle, banks stopped hedging, volatility suddenly exploded and the market tanked.

To be fair, that so-called volpocalypse was made worse because the funds tried to cover their losses by betting on even more volatility. 

Structured-product holders are unlikely to do that.

The implication remains that autocallable buyers might be overconfident. 

Right now, most notes are delivering the expected payoffs and getting reinvested, but buyers and issuers alike may be riding a bubble of artificially suppressed volatility. 

Korean autocallables have been losing investors money, which might be an early warning.

It also means that Wall Street more generally shouldn’t trust the Vix as a gauge of potential trouble. 

As Geoffrey Yu, a senior market strategist at BNY Mellon, puts it: “Low volatility begets low volatility. 

Until something goes wrong.”