Week boosted by five large deals is not enough to offset 10% year-to-date decline in volume

By Emma Trincal

New York, May 22 - The week saw five big deals, which bumped up volume to $689 million from $236 million the week before, according to data compiled by Prospect News.

But the robust volume was anecdotal, sources said, especially given that four of the deals were part of the same series coming in equal amounts from the same issuer.

Volume fell 9.68% to $13.72 billion for the year through May 18 from $15.19 billion for the same period of last year. The number of deals declined to 2,960 this year from 3,295 last year.

However, the positive impact of last week gave a boost to the month-to-date figures with sales totaling $1.17 billion, a 24% increase from $945 million in April.

Still, sources were preoccupied by the big picture and attributed most of the yearly decline to market and pricing factors.

Four $50 million deals

"Even for me, an eternal optimist, I find these numbers are a little bit disappointing. I'm not discouraged yet. But let's hope that institutions will step in," a market participant said.

"If institutional investors were to embrace structured products, it would be a good thing for our industry. It would definitely help. Structured products [are] not just for retail.

"There are a variety of reasons that make structured products compelling for institutions: if they want to invest in high yield and bypass investment-grade-only mandates; if they want to book some income; or if they want to find a more efficient way to use their balance sheet."

This market participant saw in the issuance of four $50 million tracker deals tied to high-yield and leveraged-loans reference assets a sign of the presence of institutions in the market last week. The deals surprised industry sources for their size and short duration - two of them were two months and the other two, four months - as well as for the delta one payout used in each product.

JPMorgan Chase & Co. priced two issues of $50 million each of 5% annualized return notes due Sept. 25, 2013 linked to the iBoxx $ Liquid High Yield index. Interest was payable monthly. Those products were trackers with investors receiving the index return at maturity minus a "downward adjustment."

For each $1,000 principal amount of notes, the payout at maturity was $980.70 on one deal and $980.30 on the other one plus the index return in both products.

Separately, JPMorgan priced a pair of quasi-identical deals linked to an exchange-traded fund: two issues of $50 million each of 5% annualized return notes due July 22, 2013 linked to the PowerShares Senior Loan Portfolio ETF.

For each $1,000 principal amount of notes, investors received $993.80 plus the ETF return, with exposure to any losses, on one offering. The other payout was based on $998.10 plus the ETF return for each $1,000 principal amount.

"An industry friend just called me about those products. I can't think of any reason for a retail investor to do it," the market participant said.

"Obviously, this is institutional investors stuff. It must have been used as a way to bypass a mandate. If an institution is forced to invest only in investment grade, getting access to junk bonds or leveraged loans with those notes would be a pretty efficient way to do it. It's ridiculous because even if the issuer is investment grade, you're still buying junk. But the rules are the rules. They are rigid.

"And the people who put them in place are not even clear about the type of definition they should use for credit rating. Is the credit rating the likelihood that an issuer will make good on its promise to pay you, which is what I believe it should be? Or is it the likelihood of you getting your money back? The issuer never promises to pay you 100% back. In the case of those notes, they simply promise to pay you that formula, the return of the index.

"The bottom line is those credit ratings mandates are sort of stupid. These are artificial barriers. When dealing with stupid things, the market is always going to find solutions. Those four offerings are probably an illustration of this."

The size of the deals also reflected the market's appetite for yield, he said.

"Investors are interested in going down the credit spectrum to capture the yield that they need," he said.

A structurer said, "I did see those deals last week, and I'm also scratching my head."

But he did not see the four issuances as a sign that institutions are making a push in the structured products market.

"They look pretty one-off deals to me. It's hard to figure out who did it. Could be the clients wanted to do a big size without really moving the market with the ETFs. For that kind of size they may not get the best spread, and so they may have thought that it was probably better to do it synthetic," he said.

"But I don't see a repeat trend here. It's probably institutional. Some mid-size institutions do income structured products for their balance sheet. But I have no idea who did it and why," he added.

Goodbye buffers

The current bull ride has led investors to abandon partial downside protection such as buffers and barriers when using leverage. Instead, they have migrated toward leveraged deals with full downside exposure, sources said, commenting on data compiled by Prospect News, which confirmed the trend.

Leverage with no downside protection is the most popular structure so far this year, a reverse from last year's trend.

This type of structure accounts for 21.5% of the total, versus 15.65% last year. The volume in this category of products is up by more than 24% from last year.

On the other hand, accelerated notes with either buffers or barriers now only represent 16% of the total versus 19% last year. By the same token, their volume has dropped 24.5%.

Last week's top offering fit into that product type.

Bank of America Corp. priced $147.99 million of 0% Accelerated Return Notes due May 23, 2014 linked to the common stock of Apple Inc.

The structure offered three times leverage on the upside up to a 27.65% cap and no downside protection.

"Investors understand that structured products offer a more efficient way of getting leverage than doing it themselves," the market participant said.

"If you borrow money to buy the stock, you have a loan on your balance sheet and you can potentially lose more than your notional. If you put on 100 and get three times leverage, you can lose the whole 300 exposure if you do it yourself. But with a note, the most you can lose is the initial 100.

"This is one of many examples of the benefits of structured notes. This deal given the fee was probably not institutional. But retail investors, institutional investors are beginning to understand the efficiency of leveraged notes."

The Bank of America Apple note was different, noted sources, in that it was a leveraged product linked to a single stock.

Out of 600 leveraged products issued so far this year - excluding notes with full principal protection - only 3% of the deals were linked to single stocks. Equity indexes made up 71% and commodities about 8% of the number of deals, according to data compiled by Prospect News.

In volume, stocks prevailed over equity ETFs, which only accounted for 4.20% of the total and have declined by 31% this year, the data showed.

Stock craze

"Last week was a big stock deal, not a very typical one. Yet, I'm surprised by the increased appetite for stocks," the market participant said.

For the year, stock deals amount to 24% of the total and have increased in volume by 6.5%. In comparison, equity indexes, which account for 52% of the total, have seen their volume drop by 11%.

For both the week and month to date, the data indicated a new trend with stocks representing a greater slice of the pie compared to indexes. Their market share was 56.4% of the total last week versus 8.77% for indexes. For the month, the proportion was 50% for stocks and 19% for indexes, which is unusual based on the data.

"The macro trends show that indexes and ETFs should go higher. This trend is not going the way I thought it should go," the market participant said.

"I'm not sure why. Sometimes you have institutions using stock notes for accounting purposes so that they can book it as income. It's not a tax play - institutions pay the same rate on income or capital. They just want to show they had high income.

"But this would not apply to leveraged deals. You see more of that with reverse convertibles, autocallable types of products."

Autocallable reverse convertibles have become the second most popular structure for the year. Agents sold $2.38 billion of them so far, or 17.4% of the total, an 87% increase in volume from last year, when they captured only 8.5% of the overall market.

One example of this type of product last week was the sixth largest offering: Morgan Stanley's $47.5 million of contingent income autocallable securities due May 23, 2016 linked to Bank of America shares.

The notes paid a contingent quarterly coupon at a rate of 9.25% per year if Bank of America stock closed at or above an 80% downside threshold level on a quarterly observation date. The notes were automatically called when the shares closed at or above the initial price on any of the first 11 quarterly determination dates.

If Bank of America stock finished at or above the downside threshold level, the payout at maturity was par plus the contingent payment. Otherwise, investors received a number of shares of Bank of America stock equal to $10 divided by the initial share price or, at the issuer's option, the cash value of those shares.

Bull market

The structurer saw common factors explaining the overall volume decline and investors' strong bid on stock-related products: the bull market.

"The drop in sales is a combination of the market conditions and pricing," he said.

"Volatility, rates are really low.

"It's hard to make something look good from the issuer's perspective versus a direct investment in equity, especially with the market doing so well.

"I don't think it's fundamentals here or that investors are tired with structured products. I think it's the pricing conditions and the bull market."

Commenting on deals such as Bank of America's $148 million linked to Apple, he said that investors tend to easily "fall in love" with stocks in a bull market. Pricing challenges also make such deals even more compelling.

"There's not enough volatility to offer good downside protection and good upside. If you want a more decent return potential, you need to go for a more volatile underlying. As we all know, stocks are more volatile than indexes.

"In a bull market, you see people fall in love with single stocks more than usual. There's a lot more talk about Apple, Google, etc. There are a few stocks like that ... people get obsessed with them," he said.

The top agent last week was JPMorgan with $229 million, or 33.27% of the total, sold in 26 deals. It was followed by Bank of America and Morgan Stanley.

"The bottom line is those credit ratings mandates are sort of stupid." - A market participant

"In a bull market, you see people fall in love with single stocks more than usual." - A market participant

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