Auto-callable Notes Tied to FANG and Technology Stocks

The notes are often sold to retail investors seeking higher-yielding alternatives to traditional fixed income securities. Offering documents say that buyers can earn fixed payouts of as much as 25% of the purchase price annually without taking on the risk of direct ownership in the company’s shares.

Many of these FANG-linked notes fail to produce returns anywhere near that stated range, according to an analysis of securities filings by The Wall Street Journal. Often the upfront fees banks collected were higher than the total returns earned by investors.

That is partly because an increase in the underlying stock price contractually triggers their redemption. The auto call notes are often redeemed in less than a year, and sometimes in as little as a month. In many cases the auto-callable provision leads investors to earn small returns and receive their money back long before the stated term of the investment.

When Citigroup sold $16.3 million of auto-callable notes tied to Amazon.com shares in mid-February, the firm advertised a 10% potential annual coupon for three years. Three months later, Amazon shares were up more than 20%—but the note was called, meaning that investors who purchased it received a total payout of 2.5%. The bank collected 3.5% in fees.

Banks set the schedule of the observation periods, which can be as frequent as monthly or as infrequent as annually. If the underlying stock has risen from its initial level as of that observation date, the bank automatically calls the notes.

Investors only get the full payment if the equities trade within a limited range, typically modestly below their initial level when the notes are issued. If the stock or basket falls below a given threshold on certain observation dates, the investor often doesn’t collect.

If the underlying stock has risen from its initial level during these periodic reviews, the notes get called.

Citigroup Inc., UBS Group AG and Royal Bank of Canada are among the banks that have issued in 2018 more than $1 billion worth of a type of structured notes linked to one or more of the four FANG stocks: Facebook Inc., Amazon.com Inc., Netflix Inc. and Google parent Alphabet Inc.