In the first article of this series, we compared the actual performances of several equity indices, equity ETFs and oil during the COVID-19 crisis with the PRIIP KIDs’ Stress Scenarios. We had concluded that, so far, the PRIIPs KID Stress Scenario methodology has provided results comparable to the performance experienced during the COVID-19 shock (March 2020) in the capital markets. The above holds for the “Long Stress” (i.e. the less-strict assumptions) methodology used to calculate the Stress Scenario for periods longer than one year. However, simulated performances based on the “Short Stress” parameters were much worse than the actual performances experienced.
As corporate debt yields experienced a sharp increase (i.e. the prices dropped) during the crisis, we decided to focus in this article on fixed income certificates/notes. We have reviewed PRIIP KIDs’ 1Y Stress Scenarios that were calculated before the crisis for capital protected debt instruments and compared them to actual lowest performances during the crisis.Before presenting the results, it’s important to mention that the issue of evaluating a Category 3 PRIIP at an Intermediate Holding Period (IHP) is not prescribed in detail in the PRIIPs RTS. During 2018, many Manufacturers used a risk-free discounting mechanism to evaluate the value of future cash flows at an IHP. It was apparent that risk-free discounting would not appropriately quantify the risk during a major crisis. Therefore, EUSIPA, the Brussels-based European Structured Investment Products Association, in 2018 initiated a Technical Working Group (TWG) for this matter and discussed the possibility of reaching more realistic IHP figures in major crisis times. This effort has resulted in the “Risky Discounting” methodology that assumes funding spreads significantly widen during a crisis.
More information on this topic is available at: https://eusipa.org/eusipa-rts-implementation-advice-published/
We performed an analysis on two sample products:
To start out, we chose a BBB-rated issuer and found a 7-year, 100% capital protected, EUR denominated product issued on June 2019. The product is expected to pay fixed coupons of 0.5% per annum, plus 50% participation in the upside of an underlying fund. Obviously, in the Stress Scenario we do not expect any extra return from the participation component.Upon reviewing this product’s KID, we discovered that the issuer still utilized the risk-free discounting methodology: the last KID available, dated to the end of November 2019, shows an optimistic stress scenario value of 103.66% (EUR 10,366) at 1Y IHP. This can be explained as follows:
- The product was traded around 100.90% (offer price) at the KID generation date.
- The investor buys the product at 100.90% and is expected to receive a total of 3.50% in coupons (0.5% annual coupon in each of the seven years) plus repayment of 100% at maturity.
- This means a total repayment of 102.58% (= 103.50% / 100.90%) of the investment.
- Using the slightly negative EUR risk-free rate for the product term, the discounted value is slightly higher than the expected cash flow and reaches the 103.66% specified in the KID.
In reality, the product’s bid price (i.e. what investors receive when exiting before maturity) actually fell to 92.6%. As anticipated by many manufacturers, risk-free discounting is far too optimistic and does not provide a realistic product valuation in a Stress Scenario.We calculated what would have been the 1Y Stress Scenario valuation if the manufacturer had chosen to adopt EUSIPA’s Risky-Discounting methodology: for a BBB issuer the funding spread should widen to 2.15%, on top of the risk-free rate, in a 1Y Stress Scenario. Applying this spread would discount the RHP value to IHP1 at a rate of 2.15% plus the ~7Y Euro Swap rate (minus 0.0832%), which leads to an offer price of approximately 93.7%. Applying a bid/ask spread of 100bp for early exit results in a bid price of 92.7%, a much more realistic result that is in line with the actual decline experienced during the current crisis.
- Product: 7Y EUR BBB-rated
- 1Y Stress Scenario in PRIIP KID (using risk-free discounting): 103.66%
- 1Y Stress Scenario according to EUSIPA’s Risky-Discounting: 92.70%
- Actual lowest value during COVID-19 crisis: 92.60%
For the second sample, we looked for a different currency and a different credit rating. Different currencies mean different risk-free rates and different ratings imply different discounting spreads. We chose a 6-year USD capital protected product from an A-rated issuer. The product was issued on September 2019 and is expected to pay 100% participation in the upside performance of the S&P 500 Index up to a cap of 24% (i.e. a maximum repayment at maturity of 124%). Similar to the previous product, in the Stress Scenario we do not expect any extra return from the participation component.
Upon examining the original KID generated in September 2019, when the product was in subscription, the Stress Scenario at 1Y IHP showed a value of USD 9,618.69. Although we were unable to replicate this calculation, the value reported was even higher than had risk-free discounting been applied. In reality, when Corona took the markets by storm, the value of the product on the secondary market fell to a low of USD 9,368.We recalculated the 1Y Stress Scenario using the risky-discounting methodology, where the funding spread of an A-rated issuer would reach 1.15%, on top of the risk-free rate (~5Y USD swap rate at the time of issue was around 1.45%). This leads to a product value of USD 8,822.58. In retrospective, this figure, aggressive as it is, would have been a much better figure to show investors than a value that was already breached.Analysis summary:
- Product: 6Y USD A-rated
- 1Y Stress Scenario in PRIIP KID (unidentified method): 96.19%
- 1Y Stress Scenario according to EUSIPA’s Risky-Discounting: 88.23%
- Actual lowest value during COVID-19 crisis: 93.68%
The two examples analyzed above are in line with many other examples observed in secondary markets during the Coronavirus crisis. They lead to the following conclusion: it is imperative for manufacturers of debt instrument PRIIPs to implement EUSIPA’s Risky-Discounting methodology.This message resonates louder in the market conditions we are currently experiencing.
I would like to thank my colleagues Roiy Gabzo, Eran Elad and Stefan Marcus for their contribution to this article.