The Range Accrual product type is a long established payoff within the world of structured products. It provides income or growth that pays out its maximum level if the relevant underlying asset stays within a pre-determined range, usually symmetric and two-sided. While many variations of Range Accrual exist most of them bet that the underlying will not move significantly from its initial levels.
Popular payoff in 2019
The Range Accrual is not always thought of as a core offering of the structured product market simply because it is essentially betting on nothing happening. In the long term, all markets rely on direction and volatility to sustain interest. Yet in 2019 the Range Accrual product type became the highest selling payoff according to StructuredRetailProducts.com data.
The number of products issued were relatively small, less than 9000 in total which places Range Accruals far below Auto-calls and Reverse Convertibles. Because of high average trade sizes sold the total market share across all was reported as in excess of 60%.
The use of Range Accrual spans different asset classes including Fixed Income, Foreign Exchange (FX) and Equities. In all these asset classes the basic construction is the same, the earning of income or growth provided the underlying stays within a range during the lifetime of the product. This might be an FX rate staying within a 2% range either side, an interest rate staying within 0.5% in absolute terms, or an Equity Index remaining within a larger range perhaps 5%.
The measuring of whether the underlying performance qualifies for a coupon is either calculated proportional to the number of times the underlying is in or outside the range or “one-touch” where if the underlying exceeds the range levels that period’s coupon is immediately lost. In this latter case the entire product may also be terminated. Different variations exist, the most common being ranges that move over time to better capture the investor’s view. For equities this might be the widening or increasing of the range width.
The product’s recent popularity rests heavily on the product terms that can be offered, which in turn come from the market levels of volatility which determine the pricing. In the current environment there are relatively high levels of volatility but many analysts and investors have no clear idea of market direction, or can decide that we are set for significant moves away from today’s levels in either direction. Therefore this product benefits from attractive income levels combined with a perception that market moves will be short lived and that the underlying has a good chance of remaining within the terms necessary for high or maximum levels of income.
Range accrual products have always been more common in markets where mean reversion is a constant theme, in particular Fixed Income and to a lesser extent FX. There has been an increase in usage of the product type in FX markets because of the global trade themes that have focussed investors on different countries and regions. Key example are in Asia (China versus other local economies and the US), and US and Mexico as another example.
One of the reasons why the share of Range Accruals in 2019 was so high is that significantly more Range Accrual products have also been seen in equity markets. This is also symptomatic of market views and the lack of clear direction as well as a desire for income based instruments that have good chances of earning significantly in excess of the risk free rate.
It is unlikely that this situation will persist for very long, either market sentiment will change or the level of demand will start to hurt product pricing. Structured products markets can be quite finite, in this case through the sale of short dated options (calls and puts) necessary to hedge the product. Once volumes become large enough then eventually this will cause a significant reduction on volatility levels which will reduce the level of income that can be offered. The alternative is that in order to maintain issuance at similar levels of income other features are put in such as smaller target ranges, terms that increase the likelihood that ranges are broken or other elements that increase risk.
In conclusion therefore the rise of the Range Accrual has made it an important product type in the current environment as it exploits a favourable combination of pricing and market views.