Contingent Income Auto Callable Securities: Don't Blur the Difference Between Equities and Fixed Income

I recently got a call from a broker at a well-known investment bank who was excited to tell me that he finally had a new series of high yielding products to sell. The products - called a Contingent Income Auto Callable Security - pay a fixed rate of return for a fixed period provided that a given target equity trades at our above a target price and are each issued by an investment bank (such as Morgan Stanley or Royal Bank of Canada).

After looking at several prospectuses, the issue that struck me as most interesting was a one year Note (CUSIP: 48127E510) underwritten by Morgan Stanley against the equity of Yelp (NYSE: YELP). Yelp was trading at $90 a share on the March 19, 2014 issuance, and the terms of the issue are that it will pay a quarterly dividend amounting to 15.6% a year so long as Yelp is trading at more than 50% of its value at issuance on each quarterly measurement date (i.e., the Note pays 3.90% a quarter as long is Yelp is trading at or above $45 a share). The quarterly dividend is forgone if Yelp is trading below $45 on a quarterly measurement date. At the end of the 12-month period, you receive back your full principal provided Yelp is trading above that threshold level. If it is trading below, you receive back the equity that you would hold if you were to purchase the stock on the issuance date. In other words, if Yelp is trading below $45 on March 19, 2015, you recover some percent of your principal that is below 50% and equal to the stock price on that date divided by its March 19 price of 90.

While many will feel that the downside on Yelp is negligible, it should be noted that Yelp traded at $22 a year ago, and could be shut down in two seconds if Google were to adjust its search algorithm. It should also be noted that on March 20, 2014, the day after this Note’s issuance, the stock closed at $84, having fallen 8% already. On the other side, it could double or even triple over the next year as it did over the last year. And, if it does, you will have swapped all of that upside for a 15.6% return. In other words, you are giving up your upside for 15.6% and still taking on limitless downside exposure.

The dividend offering in the Yelp Note is much greater than those offered in the other similar Contingent Income Auto Callable Securities (most offer a 5-7% yield, which in some cases is only 2x the underlying stock’s dividend) and some have thresholds where the threshold for a loss of principal is only a 20% decline in the underlying equity. In other words, Yelp is the most compelling offer that I saw in terms of yield and arguably had the least risk to principal. The other issues therefore should certainly be avoided.

But, the Yelp issue too should be avoided. As you can see from the example, you have limitless downside, and because you don’t own the stock, you won’t be able to sell the stock or even hedge it easily if it should begin to fall. You are also giving up your upside in return for a fixed yield that, while attractive, is not commensurate with the risk to this highly volatile name. To boot, you are assuming credit risk of the issuing bank.

Bottom Line: Unless you are somehow running this trade as a hedge against a short position in Yelp or can somehow otherwise hedge a contingent income auto callable security, you should avoid it.

Full disclosure: The author has never had a position in Yelp, does not have a position, and is not recommending any position – long or short – in the stock.