Complex products popular with private investors across Asia have collapsed, imposing billions of dollars of losses as the coronavirus outbreak rips through markets.
So-called structured products have flown off the shelves in recent years, led by a South Korean market valued at more than $80bn, as pensioners and other individual investors have sought out risky bets offering high returns.
But these instruments, which are tied to everything from US government bonds to European stock benchmarks, can come back to bite investors when volatility spikes.
Mr Lee, an office worker in Seoul, has already seen some of his investments linked to oil prices take large falls in value, and is now worried that other equity-linked products will crumple.
“No one knows when the coronavirus pandemic will end,” he said. “Many people are constantly checking stock markets overseas and are panicking about the current situation.”
When markets are calm, structured products tend to act like lower-risk securities such as bonds, steadily paying out an annual coupon until maturity. But the higher-than-average yields they offer come from additional revenue supplied by options.
In exchange for better returns, the investor might, for instance, agree to buy an asset at its original price if it falls below a certain level. That exposes the investor to the risk of significant losses.
Products are usually tied to assets or indices local investors are familiar with, and are confident will not suffer a sustained and serious fall. But during extended periods of low interest rates, the banks selling the instruments have grown more creative to deliver high returns.
“The lower the interest-rate environment, the more these banks will try and come up with ways to get a nice and juicy coupon for clients,” said a trader at one Hong Kong-based hedge fund who previously worked in structured finance at an investment bank. “You increase the risk to increase the coupon.”
Investors’ search for yield has helped make Korean structured notes the region’s most popular, growing about fivefold over the past 10 years. The market had a total value of around Won104tn ($83bn) at the end of February.
But buyers risk losing their original investments if the price of the underlying asset falls below a threshold known as the “knock-in” barrier. While each product is different, that barrier can be anywhere from 35 per cent to 60 per cent below prevailing prices.
Other products link investors to a host of seemingly unrelated assets across the globe. One such offering comes in the form of “worst of” products. These tie the extra yield to a handful of reference points such as South Korea’s Kospi index or the Euro Stoxx 50 index. If just one of these crashes through the barrier the investor can face huge losses.
The recent sharp fall in oil prices jolted investors such as Mr Lee, who have a collective $1.5bn of oil-linked products. But after a broader plunge across global stock markets, risks have risen in as much as $50bn of equity- and derivative-linked products.
More than 60 products sold by the top Korean securities firms — including Mirae Asset Daewoo, NH Investment & Securities, Shinhan Investment and KB Securities — have already hit knock-in barriers over the past week. Typically, these notes have a three-year maturity, implying around Won1.7tn ($1.4bn) maturing each month.
But at the same time as investors face losses, the securities firms that issue the products are also left with a problem.
Those sponsors tend to buy US government bonds and Korean corporate debt to support the payment of coupons on the notes. So if a lot of investors rush to cancel their notes to get some of their money back, the banks could be forced to offload a large amount of assets quickly.
“If there is a massive sell-off [of the notes] there is a risk that the securities companies might need to sell off their corporate and sovereign bonds at the same time, which might have some significant impact on markets,” said Tae Jong Ok, an analyst at Moody’s. “Those risks are not usually seen during normal times but they do pop up whenever there is some volatility in the market.”
Some sponsors are just lamenting lost business. One banker said his bank’s sales of one product tied to US interest rates could top $20m a month as wealthy retail investors from Hong Kong, Singapore and Taiwan lapped them up.
But the products were structured so that the further US interest rates fell below 1 per cent, the more money investors lost. When coronavirus started really pummelling the global economy, the Federal Reserve slashed benchmark rates to nearly zero — taking sales of these products to a similar level. “Now it’s all gone,” the banker sighed.
Additional reporting by Kang Buseong