The stock market's recent serenity might be a mirage, fueled by a surge in a complex financial instrument: structured products. While their popularity offers a sense of security, it could also be masking a ticking time bomb for investors and the market itself.
Structured products, once a European domain, are exploding in popularity globally. Sales in the U.S. soared to a record $132 billion in 2023, a staggering rise from $78 billion just three years prior. The most prevalent type? "Autocallables," particularly popular in Asia. These bank-issued notes are linked to an underlying asset, like the S&P 500. If the index remains within a specific range on predetermined dates, investors receive generous payouts. If it surpasses a certain threshold, the note is redeemed early. Often, they offer some protection against losses.
This seemingly attractive bargain appeals to less-experienced investors seeking income and a safety net in today's low-interest-rate environment. Structured products, once yielding as much as 10%, became an enticing alternative to traditional options like time deposits and bonds. Banks, of course, benefit handsomely from the hefty fees associated with these instruments.
The recent uptick in structured-product sales might seem counterintuitive. After all, central bank tightening has revitalized interest in traditional investment options. However, banks have cleverly adapted, tailoring attractive notes around higher-yielding bonds. Moreover, the stock market's stability since late 2022 has played a critical role. Equity-linked autocallables are essentially bets against volatility. Investors want moderate upwards movement, but a sharp correction sends shivers down their spines. These products share similarities with "covered call" strategies employed by popular ETFs, which have also witnessed significant inflows.
Here's where the plot thickens. While inflation, geopolitical turmoil, and shifting monetary policy paint a picture of global economic uncertainty, the very instruments designed to mitigate these risks might be artificially suppressing the market's volatility. In a recent report, the Bank for International Settlements (BIS) raised a crucial flag. Banks selling structured products are forced to hedge against investors' bets. To do so, trading desks engage in "delta hedging," actively countering market swings by selling stocks when they rise and buying them on significant dips. This constant intervention weakens long-term volatility, making it cheaper to hedge against future fluctuations. As a result, the widely tracked Cboe Volatility Index (Vix) remains unusually low.
The irony is stark. Autocallables appear attractive because of the market's calmness, but that calmness is largely a product of so many investors buying these instruments. It's a self-fulfilling prophecy reminiscent of the "volpocalypse" of 2017-2018, where funds heavily betting against volatility ultimately fueled a market crash when the cycle broke. While structured-product holders are unlikely to engage in such aggressive doubling-down strategies, the potential for overconfidence remains. Currently, most notes are delivering promised payouts and being reinvested. However, both investors and issuers might be unwittingly riding a bubble of artificially suppressed volatility. Korean autocallables, for instance, have already begun to inflict losses on investors, potentially serving as an early warning sign.
The implications are clear. Wall Street cannot blindly trust the Vix as a reliable indicator of potential market trouble. As Geoffrey Yu, Senior Market Strategist at BNY Mellon, aptly states, "Low volatility begets low volatility. Until something goes wrong." The question looms: is the market genuinely calm, or simply lulled into a false sense of security by the hidden hand of structured products? Only time will tell when the true underlying volatility will break free, potentially exposing the market's vulnerability and challenging the perceived security of these complex instruments.
