China’s rich return to risky ‘snowball’ derivatives for yields
The stock market has since rallied further, sending many snowballs and DCNs through the knock-out levels
[BEIJING] China’s wealthy are once again pouring money into “snowball” derivatives for juicier returns, a year after the regulator curbed the product that was blamed for exacerbating a stock rout.
High-net-worth investors have snapped up tens of billions of yuan of revamped snowball derivatives since the beginning of this year as interest rates remain low. China Merchants Bank alone has distributed more than 30 billion yuan (S$5.4 billion) of such products issued by brokers, according to sources familiar with the matter who asked not to be identified discussing private information.
While the latest versions on offer claim to be less risky, most products still tout annualised returns of about 20 per cent, according to China International Capital Corporation (CICC). Some products are delivering annualised gains as high as 71 per cent in rare cases, according to market data seen by Bloomberg News.
The revival in what are now called “quasi-snowballs” comes about a year after regulators cracked down on the product, seeking to temper retail investor interest as brokers promoted record returns despite steep declines in stocks. The push underscores the dearth of high-return opportunities as interest rates have slid in China amid an effort by officials to prop up growth.
The China Securities Regulatory Commission did not reply to a request seeking comment. China Merchants Bank declined to comment.
Snowballs grant investors bond-like coupons as long as the stock index they reference stays within a predetermined range – typically between 75 per cent and 105 per cent of the starting level. A “knock-in” occurs if the lower end of the range is breached, handing the investor a potential loss equivalent to the drop. When the market gains to the “knock-out” level, the investor gets paid the coupon for the holding period as the contract is terminated.
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The new quasi-snowballs have been redesigned to extend maturities and have fewer knock-in observation days, reducing the risk of losses.
“The risk-return profile of snowballs is still attractive,” said Liu Fuchen, co-founder of Galaxy Technologies, which provides derivatives trading and risk management solutions. While stock indexes have risen quite a lot in recent months, the current market conditions remain “quite suitable” for snowballs, Liu said.
After years of declines in stocks and the housing market, as well as weaker returns on other investment products, the snowballs with high coupons have become “an oasis amid the asset drought”, according to Shanghai Suntime Information Technology, a consultancy firm.
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Regulators, ever wary of instabilities, remain on high alert after raising the lower limit for investing in snowballs to 10 million yuan from one million yuan last year to exclude less experienced investors, and introduced caps on the outstanding size of the business.
Dynamic coupons
Similar products for less wealthy investors have also emerged. These are known as Dynamic Coupon Notes (DCNs) and require a minimum investment of one million yuan. They use a similar underlying structure and pay monthly coupons of about 1 per cent. A small percentage of such products can add leverage, more than 300 per cent in rare cases, typically based on needs from professional investors. A loss occurs only if the underlying index is below the lower threshold on the maturity date.
In April, CICC estimated the total market for snowballs and dynamic notes was about 100 billion yuan. That’s about half the size of what it was at the beginning of 2024, suggesting market disruptions like last year’s are unlikely. CICC analysts expect the yields and size “may rise rapidly for the short term”.
The stock market has since rallied further, sending many snowballs and DCNs through the knock-out levels. In one case, a product linked to the CSI 1000 Index hit its 103 per cent knock-out just three months after being sold in mid-April, handing investors a roughly 18 per cent return during that period, according to the market data.
Many investors are probably choosing to re-invest their knock-out money into snowballs or DCNs, according to Liu. There’s a growing conviction among investors that any correction in the next year or two will not be steep enough to hit the downside cushion of the products, especially given the government’s commitment to support the market.
“With such expectations, investors would feel the risk is relatively low,” Liu said, adding that current buyers tend to be more sophisticated and experienced than before. “And if you can meanwhile collect a coupon of more than 10 per cent or 20 per cent, you would feel it’s a fairly good deal.”
Still, the extended maturities – many are now up to three years – and the absence of knock-ins during the holding period can increase risks facing brokerages that serve as counter-parties. The issuers may maintain aggressive pricing to compete for market share, amplifying the risk of potential losses if market conditions shift.
Should stocks continue to edge higher, more knock-outs will be triggered, allowing brokerages to keep the snowballs rolling even as they comply with a cap imposed by the regulators.
“We will likely see the issuance continue, one wave after another,” Liu said. BLOOMBERG
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