CHINESE securities firms are dangling near record-high returns to lure investors back into the market for derivatives that fuelled the nation’s stock sell-off earlier this year, as fallout from the meltdown cuts deeper into their profits from the business.

Two “snowball” products issued last month offered coupon rates of more than 40 per cent, a level unseen since at least 2022, according to data compiled by Galaxy Technologies. Five brokerages raised the yields on products linked to the CSI 1000 Index in March from the previous month, while six others including CSC Financial joined the fray, pushing a GalaTech measure of the average price to a record high, the data show.

Brokerages are fighting to win back snowball investors after the market rout earlier this year, when most products fell through levels that threatened to wipe out coupons or even impose losses. The intensifying price competition is adding to pressures on profitability as firms seek to revive sales to help offset mounting hedging losses.

“A price war has started,” said Liu Fuchen, co-founder of Shanghai-based GalaTech, which also provides derivatives trading and risk management solutions to financial institutions. “The current environment certainly can’t support such high coupon rates, and securities firms will face huge profitability pressures if they keep issuing products like this.”

An estimated 330 billion yuan (S$62 billion) of snowballs were outstanding as at November, according to UBS Securities. The exotic products pay investors bond-like coupons as long as the stock index they reference stays within a predetermined range.

If the index rises above the range, then a “knock-out” is triggered, in which the contract terminates and the investor receives the coupon for the period to date. If the index drops below the range, then a “knock-in” occurs, in which the holders receive no coupon and potentially lose part of their capital unless the index rebounds to hit the knock-out level before maturity. The longer the investors hold the product, the bigger the return – like a rolling snowball.

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Coupon rates in recent years have typically ranged from 10 to 20 per cent. The products have been lucrative for brokerages, which hedge their exposure using stock-index futures and generate extra income by investing part of the proceeds. The discount of index futures, which persists in the Chinese market, often adds to the profit. The products are often distributed by hedge funds.

Major setback

But the business suffered a major setback in the first quarter when the majority of existing products’ underlying stock indices slumped below knock-in levels. That meant brokerages had to sharply increase purchases of stock-index futures and later sell them to limit risks under the so-called delta hedge. The process exacerbated the slump and likely imposed losses on the brokerages, according to Liu.

On top of that, the firms have since had to switch the hedging strategy for contracts that knocked into the opposite just as the market started to rally in the following weeks amid the government’s unprecedented intervention. The switch required them to buy more index futures when prices rise and sell when they fall to stay delta neutral, even though it’s a lossmaking proposition.

That’s eating into the profits of a business which, according to Kaiyuan Securities estimates, contributed about 2.5 per cent of net income at China’s listed securities firms last year. Other sources of profit from snowballs can hardly compensate for the hedging losses and still leave enough money to pay the coupons should the indices rebound further to hit knock-out levels before maturity, according to Liu. The CSI 1000 has jumped 23 per cent from its Feb 5 low.

As a result, brokerages are facing pressure to sell new snowballs and start fresh “buy low, sell high” hedging positions, he said. “It’s their best solution. So if some very popular products with high coupons can help revive snowball sales – even though the pressures on near-term profitability are huge – they will be more than happy.”

A Shanghai-based hedge fund manages the two highest-return snowball products sold last month, which raised about 110 million yuan. A securities firm will provide the hedging, and while the coupon rates for the first year are high – at 41.2 per cent and 42.2 per cent – they showed its confidence in its capabilities, according to a spokesperson for the fund. He asked not to be named or identify his firm or the brokerage, citing policies on such private offerings.

Separately, CSC Financial did not reply to a request for comment.

Boosting overall sales is no easy job, as even some experienced investors have lost faith. Sophie Yu, who works at a financial company in Shanghai, said she’s slashing her holdings of snowballs to 20 per cent of her investments from 50 per cent. Two products that she held knocked in in February, after her efforts to negotiate lower trigger levels with her brokerage failed.

Yu said the products are designed to the disadvantage of investors because they are only given one day each month for a potential knock-out, while a knock-in can happen any day the index is low enough. Clients also should be given more flexibility such as the option to exit early with their principal by giving up the coupon, or to extend the contract’s maturity by one year when needed, she added.

Only seven new snowballs were issued in the tumultuous week of Feb 5 right before the Chinese New Year holiday, close to the fewest in a year, according to GalaTech data. The first quarter saw 133 new offerings, slumping from 383 a year earlier, the data showed.

Risk appetite

Much of the hope lies in investors such as Dora Zhong, who bought her snowball with one million yuan in January thinking the timing was safe enough to get a 12.5 per cent return. The market fell further, and her product knocked in. Still, the rally in the CSI 1000 has brought her close to a knock-out, where she can pocket the return.

“What’s good about snowballs is that they have clear return features – with the coupon rate much higher than bonds when market volatility is high – although it could have extreme tail risks,” Zhong said. “I would still consider buying more when the conditions are right. Even if I had to take a loss, it’s acceptable.”

Brokerages are also offering revised product structures to meet investors’ changing risk appetite. They have been issuing snowballs with lower knock-in thresholds, and recently focused more on so-called phoenix products, which are more liquid and pay a monthly dividend as long as no knock-in occurs.

When Yu Zheng, who works in the southern city of Guangzhou, bought a snowball with a descending knock-out line in May, she also thought it was safe. “I just did not expect a hit like that in February,” she said, adding that she’s still calm as there’s more than a year before maturity.

“I would still consider suitable products, like a phoenix structure,” said Yu. “I just have no more money now.” BLOOMBERG