Talk Your Book: Autocallable Income

0:00Today's Animal Spirits Talk Your Book is brought to you by Calamos. Go to Calamos.com to learn more about their brand new Calamos auto callable income ETF. It's ticker CAIE, Calamos.com to learn more.

0:38positions in the securities discussed in this podcast.

0:45Welcome to Animal Spirits with Michael and Ben. Michael, I gotta be honest, a lot of times when we have these talk your book segments, sometimes we'll do a little bit of research, but most of the time, if I've never heard of a strategy, I want to go in kind of blind because I want it to seem like we're - We're gonna do it live! Yeah, well, I want us to be the eyes and the ears of the audience in terms of learning, and a lot of times we're learning on the fly, and sometimes it's because these strategies are all so new. I've got to be honest. I didn't know what an auto callable was coming into this.

1:15Did you? I did only because of our previous dive down this rabbit hole. Okay. I just not something that I'm completely familiar with as we move these like structured note products into the ETF sphere. And a lot of the structured note stuff that we've talked about in the past is more low octane, right? We're putting guardrails so the downside is defined, but it also caps your upside. You have certain levels you pick, but there are also ways in the structure of node arena to have a little bit more juice and more volatility. And so I'd say this is one of those types of strategies, right? Where this isn't the other ones where your downside and upside are capped.

2:00It's like there's higher income and with that higher income comes more volatility. One of the things that we're trying to do on this show is to make sure for every investment that we speak to, especially if it's a new category like these autocallables, these structured notes inside of an ETF wrapper, is do our best to ask the questions that you would ask because with everything, especially income products, I think people get enamored with the sticker yield. And that's about as far as their diligence goes. Right. As long as I get the income, I'm fine. I don't care what else happens. Yeah. So you have to understand that no free lunch exists in the world of investing.

2:48And if you're getting X, you might give up a sum of Y. And so this was a very interesting conversation. I suspect it is going to be a popular category among advisors and their clients, because this is the easy button for structured notes, for turning price total return into income, which we know people love. So something in the water these days, but it seems to be a structural shift. Don't think it's going to be slowing down anytime soon. Is that a play on words there? Structural shift. But the thing, I mean, the biggest question you ask here is what's the trade-off, right? I'm getting this yield.

3:28What am I giving up or what are the risks? And the great thing about the people we talked to on this show is that they're always willing to go because you're right. There is no free lunch. So we talked to Matt Kaufman from Calamos again. He's a senior vice president ahead of ETFs. We've talked to him before and he does a really good job of looking at both sides, the pros and the cons, the trade-offs. Here's what you get, but here's what you're giving up to get this. And here's the potential landmines and all that stuff. So we get into all that with the new Calamos auto callable income ETF. It's ticker CAIE.

3:57So here's our talk with Matt Coffman from Calamos.

4:04Matt, welcome back to the show. Michael, thanks for having me. All right. The big trend or one of the big trends in ETF land, as Matt Levine has been writing about, is that anything that can be ETFed will be ETF. And the product that we're going to be talking about today is the perfect example of the evolution inside of this magical wrapper. Today, we're talking about the Calamos Auto Callable Income ETF. And this is a very interesting product. Ben and I did a cursory look over this and said, you know what? Saving it for the show. I want to come and clean. So here we go. Matt, what's the story?

4:43No, I appreciate that. I think there's a question of can and should on the ETF side. You know, anything that is liquid and can be developed in, I would say, a structured note type wrapper can be very efficiently delivered in ETFs. And so that's what we're doing here. If you follow the derivative income space, there is a massive derivative income revolution happening inside ETFs. You've seen JEPI, JEPQ, everybody's talking about that. Those are all large covered call strategies. They're derivative income strategies. They make up$115 billion in the ETF space. Whoa. If you go over - JEPI is still the largest active fund, right?

5:27Which is crazy. Yes, exactly. That income fund is that large. It's a derivative income fund. If you go over to the structured note world, it's no different. Derivative income still dominates, but it's dominated by a strategy called auto callable. And an auto callable is essentially a yield note that pays a coupon tied to an equity reference index. So most structured products do that. They give you something based off the performance of something else. So they give you a coupon. They give you performance. You look at other types of structured products like buffers or principal protected notes. They give you an outcome based off the performance of an underlying equity index.

6:09Now, can we just pause here for one second? Yes. Absolutely. So when you say they give you yields, so for example, an investor could say, okay, I want to buy this structure note. And let's say that we're using a basket of two indexes, the Russell, the S &P, whatever. And I'm going to have a 12-month maturity such that if neither of those are more than, I'll make up a number in a 30 % drawdown at the time of maturity. I'm going to get a, again, making this up an 8 % yield. Cool. That sounds like a fair trade-off. Is that, that's what you're talking about? Yeah. I think, I think you're jumping, jumping pretty deep in the weeds there, but the, the headline is that you get a coupon based off the performance of an underlying index.

6:50And so that coupon is stable. So long as, as you said, the underlying index doesn't fall below a certain level. So you're taking on that deep in the money tail risk in exchange for a high stable coupon payment. So if you view the covered call strategies as buying protection or buying insurance, the reverse is true with an auto call. You become the insurance company. You are selling insurance in this instance. So you want to avoid the crash. You want to make sure that you're not getting into that deep, severe, sustained market decline. But that's the tail risk you're taking on. And there's$100 billion in the United States alone worth of people looking for that high income coupon tied to that equity market barrier.

7:36So it's a massive space. We are bringing that to the ETF market. We launched yesterday. There's a tremendous amount of feedback and positive reception already. It's been one day we're seeing a ton of people have interest in this. Talked to one advisor yesterday who said, you know, this was her words. This is the easy button for me. This is the auto call easy button. I usually have papers scattered all over my desk. I have to go shop for individual notes, find the right one. I get called away in six months or so, and then I have to do it all over again. I have coupon reinvestment risk. I have maturity risk.

8:13I have timing risk. All of my money's tied to a single point in time. We've solved all of that with this ETF. We have a laddered portfolio of auto calls. So you're diversifying your maturity risk, diversifying all of that timing risk out. And then we're tied to a single underlier, a single reference index that's been optimized for autocall. So every time an autocall gets essentially called away inside the ETF, we just buy a new one in the ladder. There's no more work for the advisor to do. They don't have to go shopping again. They can get all the paperwork off their desk, and it gives you a really simple, easy to implement ticker.

8:52So all these different structured note-like products that are now being turned into ETFs. Some of them, it's downside protection. Some of them, it's like getting more upside. Some of them, it's putting guardrails and having a defined downside and defined upside. What is the return profile hope for this type of strategy? I love that question. Let's make a curve. So if you make a curve of all of the different defined outcome or called structured note profiles in the market, all the way at the top, you have levered exposure. ProShares, they've got that covered. There's other firms' direction doing those types of levered exposures.

9:28You can get that in structured note form also. You go to the other end of the spectrum, you've got principal protected notes. We launched 100 % capital protected ETFs about a year and a half ago, capturing that principal protected note space or FIA, if you're familiar with insurance companies. So then in the middle, you've got buffers. You've got something less than 100 % protection, not quite levered. The one space that has not been captured happens to be the largest. It's the auto callable market. It's very large all over the world and it's the income category. People are hungry for income. You see it in derivative income ETFs, you see it in structured notes.

10:06And that space is essentially a very long dated put replication strategy. You cannot go to the listed markets to build these, which is why we would partner with and collaborate with a counterparty like JP Morgan to then bring this into the ETF space. So it's a very clean structure. We've built an index with Mercube, one of the leading index providers in the country. They have the index that has the laddered exposure to all of the auto calls, all referencing the Mercube US large cap vol advantage index, long name. And that whole thing goes up into a point. We trade that price, that index on swap with JP Morgan.

10:48And so advisors and investors can get auto callable exposure to a diversified basket of auto calls, all with a single trade. Why do you think it took so long for this wrapper to come to market? Because I am suspecting, I was about to say I'm afraid, I'm not afraid. I suspect that this is going to be a large success. I suspect that advisors are going to gobble this up on behalf of their clients. And of course, I want to make sure part of the reason why we do this show is that everybody understands what they're getting into, the questions to ask, some of the potential risks involved that they might not be thinking about.

11:25But before we get into all of that stuff, why did it take so long? Is there a bunch of complexity involved? Well, to use our same curve, I was involved in the IP for the buffered ETF space, which was replicating a buffered note. That was the best trade when interest rates were at zero. When interest rates are at zero, you cannot give someone 100 % protection. You got to do something less. So we built the buffered space, built that with ETFs. You can now deliver that into the market, tax efficiency, liquidity, all the good things. We're up the adoption curve on buffers. I was at the Morningstar Conference, saw you guys there behind the glass and doing your show.

12:03And it was interesting because eight or nine years ago, we approached Morningstar and said, you ought to have a buffer category. This is going to be big. They didn't necessarily agree with us at the time. They do now. There was a buffer ETF panel. There's a buffer ETF category in Morningstar. And now rates are higher. So now we can do the 100 % principal protected space. That has been ETFed, if you will. We can capture that now. The next iteration is the auto callable space. You cannot replicate an auto callable precisely with flex options like you can do a principle protected or buffered strategy.

12:41You've got to go out and use a swap. You've got to use a counterparty or some you could own notes. I think the most efficient way to do it is using swap. And so now we've got all the pieces in place to actually deliver this into the market. We have a reference index. We have an auto callable index that does all of the heavy lifting, all of the replication of the notes. We have JP Morgan as the swap counterparty. We're trading swap back and forth with them. Calamos is one of the largest alts managers in the country. So it took the collective efforts of all three of us over several years to be able to put this type of strategy into market.

13:19And you're just now seeing the pinpoint of the adoption curve with the launch yesterday. So we talk five years from now, I think that these are going to be bigger than a lot of the other outcome-based categories we're seeing. Last point is I would not categorize these as defined outcomes or buffers. This is truly an auto-callable space that needs a name of its own. So this is something different? 100 % different, yes. So if you're an advisor looking through these different strategies, how would you explain each of those buckets to your clients? Because that's the big thing is getting clients to understand and be okay with these things.

13:56Yeah, absolutely. So if you're familiar with autocalls, this is the easy button. There's a lot of financial advisors out there already using autocallables for their high net worth investors. They are seeing this as a tremendous innovation, a way to give accessible autocallable access to their clients. If you're not familiar with auto callables, I think the easiest and simplest way to think about it is like a bond whose income and principle depend on the stock market not falling too far. So we want to make sure that people understand this. There's an education that needs to take place. You're taking on deep in the money tail risk.

14:35So the global financial crisis, those instances, you would lose some of your principle in those notes that you'd be buying. But other than that, you're getting that high stable coupon in exchange for taking on that deep in the market tail risk there. What does high stable income look like? If you look at the index that we're trading swap on right now, the coupon is about 14.7%. Whoa. Okay. It's material. Yeah. What drives that? And on the low end, let's assume 14 is the high end. I think anything higher, frankly, I'd be a little bit suspicious. What about on the low end and what would cause it to go lower?

15:11Is it a falling stock market? it as an interest rates? What is it? It's all the things that contribute to optionality. So if you understand options, we can keep it high level. You have interest rates, you have dividend yield, you have volatility. So you mentioned a worst of, if you look historically at the auto callable space, came out just before the financial crisis. Calamos is the largest convertible bond manager in the country. The original name of the auto callable came out as a reverse convertible. So if you're familiar with a convert, a convertible converts to a stock on the way up. Well, a reverse convert would convert to a stock on the way down.

15:48That was the first iteration of what's now known as the autocalls. As that space matured, they started to get into what you were mentioning, a worst of strategy, where, OK, I'm going to give you a high coupon based off the worst performing of one or two or three assets like S &P, NASDAQ or Russell. I don't know many people that actually like that idea of getting the worst of something, but they take it because then you can get a high coupon for that. Well, the question is, what if you stabilize some of those parameters in the options? What if you stabilize volatility? So the reason people like those worst ofs is when one of those indexes has a vol event, goes down and vol spikes, they move in because they get a really high coupon and they move a bunch of money in and try to capture that high coupon.

16:35What if you stabilize vol around a high target? Now you can deliver that high coupon very consistently. And so that vol control is underlying the reference index that we're using with Mercube. That has been around for decades. Insurance companies have been doing volatility control for a long time. So as markets are not risky, if the S &P 500 is low, from a volatility perspective, your volatility is levered up a little bit. And then if vol is very high, then vol comes down to meet that vol target. But what it results in is a very high stable coupon, historically, you know, 11 to 14, 15%. So you have that high coupon.

17:15What does the underlying movement look like in between? And I'm curious, is this another one of those that you have to sort of hold for a year to get the actual outcome? No, you don't have to do anything like that. This pays a monthly coupon. You can go to our website, calamos.com, go to the ETF page, C-A-I-E, and you'll be able to see. We give you tremendous transparency, more than anybody has ever done on a structured note. You can see exactly all of the underlying auto callables, what the coupons are, how many are paying a coupon, where they are relative to the maturity, the coupon barriers.

17:50It's all right there. And you can see right now that the index we're trading swap on is a 14.7 percent coupon. Every one of those auto calls is paying that coupon. It's a monthly distribution. And then those notes all trade at a premium or discount because they're like bonds. So if the market is down, there's actually a very cool opportunity there because you're going to be trading at a discount, almost like a rubber band. So as long as that rubber band doesn't break, fall through the barrier, you're going to go back to par. So there's historical years on that index where you would have earned that coupon and captured significant appreciation.

18:26And obviously, the closer you get to maturity, those ones end up coming back or trading at par or premium. The most common happening or happenstance is that those notes are auto-called, like that's in the name. So each of them has a one-year non-call period. And then after that, they can get called away. So if the reference asset is positive after one year, those notes get called away and the principal gets reinvested back into the new rung. Back to my original question. How much is the underlying moving? How much volatility is there outside of the yield? Is there a lot of movement in the strategy in between these periods of income?

19:03So the notes are mark to market. The investment experience you will receive, what we've seen on that index level, is a little bit more volatile than the S &P 500. So about a 20, 21 % volatility is what we've seen historically. And in exchange, you get that high coupon. And if you track that over 10, 15 years, you look a lot like the S &P 500 over time. Which makes sense that if you're getting that high of a yield, you would expect there, it's not free. There is no free launch, And if you track it over 15, 20 years, the total return of the S &P about matches the income you would have received on a net basis.

19:40So then the obvious question is, why would you do that? Like, why would you? I mean, I guess this would obviously be preferably done in a qualified account. Otherwise, you're just going to lag because I would assume that this option is ordinary income. No, it's not. Okay. So tell me, why would you do that? This has the risk return profile ultimately of the S &P, but you're turning the price stream into an income stream. I would assume that's for income purposes, for spending purposes. And hit on the tax stuff too, please. That's exactly right. Yeah. So any reason somebody would buy derivative income is the same here.

20:15People are hungry for yield, hungry for income. They use equity markets as a differentiator from credit or duration to get that. So anybody looking for differentiated sources of income would be looking at the auto call market. That's where the appeal is, getting that high coupon. In the note world, a lot of that is distributed as ordinary income. When you do this inside the ETF, specifically inside a swap-based ETF, well, now we'll have a little bit of distribution of ordinary income from the collateral. We have to hold collateral, so you're distributing that SOFR rate. And the rest of that, our anticipation is that for that to be return of capital, not return of actual money.

20:58not return of your actual capital, but treated as return of capital. So that's a remarkably more efficient tax treatment than anything that we've seen on the auto callable side. But preface that with this is not tax advice. All right. I was about to say, obviously consult with your tax person on this, but this is the type of thing as you're describing it, I could see the quants hating this and poking holes and be like, why would you pay? What's the basis? How much does this cost? 74 basis points. Okay. Why would you pay 74 basis points when you could just create the income stream yourself, just sell S &P or whatever?

21:35But I think what they would miss, and not that that's an entirely not valid argument, but this is the type of thing that advisors will love because it's scalable. Because if you are doing this on a client-by-client basis to do all these Q-sips, to do all of this, to reinvest when these things do get called, It's a pain in the neck. And this is the ultimate easy button. I agree. I think this is definitely the ultimately easy button. Paying yourself from capital appreciation is not a bad strategy. I think the hard part is getting people to do it. You know, I've been trying to get people to use capital appreciation and then pay themselves from that for a long time.

22:15You know, there's hundreds of billions of dollars, if not trillions, invested in income paying instruments. People want income and they want their funds to pay them that income. Yeah, you might think it's irrational. It doesn't matter. The proof is in the pudding. Like people that hate dividends, like, oh, you could just give yourself a dividend, just sell. No. I mean, yes, in theory, but in reality, we're humans and we like things to be easy. So what's the worst case scenario? You said like the GFC, which the stock market fell almost 60%. What does it look like in that situation? And maybe that's an extreme outlier, obviously, but maybe what's a run-of-the-mill situation where the volatility gets you somehow?

22:55Yeah, so we've designed that underlying reference index. The Mercube US Vol Advantage Index is designed for autocallables. It's designed to optimize that income. So if you look at the rolling historical returns of that, the odds of that index being down below the 40 percent barriers, which is where these notes are struck, is remarkably low. So the global financial crisis is that time where you would have knocked in on some of your notes and lost some of the principal. The important thing here is if you bought one note back then and you knocked in, you would have lost some of your principal value.

23:31So the way a barrier works is if it's a 40 % barrier, if the market's down 30%, you still mature at par. You still get your money back. If the market's down 40%, you've lost 40 % of your principal. It's a knock-in barrier. So the odds of this index knocking in were remarkably low, and the global financial crisis was when you would have done that. But if you ladder this over 50 plus notes, well, now if you've knocked in on one of the notes, you've lost 40 % of your money on 150th of your portfolio. And so it's a remarkably more efficient way to deliver access into the auto call space. But you talked about your portfolio applications.

24:14We're seeing people look at this and use it as an equity alternative. If you think you're entering a low or slow growth equity market, maybe you think GDP is going to be low going forward. 14.7 is higher than the average return of the S &P. Why is that yield so high right now? It's largely because we stabilize that volatility in the underlying index. So in April, the yield wouldn't have looked quite as juicy. It looks about the same. Again, our vol is about stable. People might have bought those worst ofs during that vol spike, but our vol is stable. So if you hit a big vol event where vol goes to 70, our vol target's 35.