Caution, not complacency driving structured products sales, sellsider says; volume up 42% for year

By Emma Trincal

New York, Aug. 9 – Issuance volume in structured notes this year continues to grow as markets hit new record highs and investors choose to remain exposed to equities but with less risk, a sellsider said, commenting on figures compiled by Prospect News.

Agents priced $30.46 billion this year through Aug. 4, a 42% increase from $21.48 billion issued during the same time last year, the data showed.

Yearly volume on a rolling period is up as well. In the 12 months to Aug. 4, sales grew to $47.7 billion from $37.23 billion in the same period a year earlier, a 28% jump.

“Our own volume is up a lot too. We’re doing more deals and our volume has tripled as we’re getting new adopters through our marketing effort,” the sellsider said.

Indeed the number of offerings has jumped nearly two-thirds this year to date to 7,875 from 4,835 in the overall market.

Careful bids

All agents have seen the number of their offerings go up this year compared to last and almost all of them have recorded volume pick-ups.

For this sellsider, the current market environment encourages investors to look at structured products as an alternative to buying stocks or equity funds.

“People are cautious, which leads them to consider structured products that have some hedging components built into them,” he said.

“At these levels, with indices at all-time highs, people understand they need to be in equities but they want to do it in a more cautious way either with some downside protection or through leverage, which allows them to put less money for the same exposure.”

Volatility

Last week was strong on the equity side. The Dow Jones industrial average set a new record high following a strong job report on Friday. While political uncertainty remains, better-than-expected earnings were investors’ main focus.

In addition, the Federal Reserve has remained accomodative, causing no shock or surprise and keeping volatility at record low levels, he said.

The CBOE VIX index, which measures the implied volatility of the S&P 500 index, hovered around 10 last week at still record lows.

“I get calls, people saying today [Wednesday] the VIX is up double-digit. But this is nothing, at least for now. Going up that much from a small number doesn’t mean much,” he said.

Geopolitical tensions between North Korea and the United States on Tuesday triggered a surge in volatility on Wednesday.

The VIX index closed at 10.28 on Tuesday and opened at 12 on Wednesday.

The “fear gauge” finished below 10 at 9.81 on Friday.

Also any spike in the VIX does not necessarily impact pricing right away, this sellsider explained.

“The VIX is to volatility what the Fed Funds rate is to the yield curve. It’s very short term. It doesn’t reflect what’s happening on the long end of the curve. When you put together notes, you’re not pricing them off the VIX. We get calls from financial advisers about volatility today. But it takes time for short-term vol to move up on the longer end.”

Single underliers

With volatility still low in spite of global uncertainty and the postponing of pro-growth policies in Washington, issuers have been using correlation as a risk generating a more reliable premium, the sellsider noted.

Worst-of deals have become one of the most popular structures on any given week. Last week, strangely, none of the top 16 deals used this type of payout. All of the largest offerings were linked to a single asset, whether be an index, a basket or a stock, according to the data. Most underliers were indexes.

“I don’t know if this is the start of a trend. I really doubt it,” the sellsider said.

“Given that rates are so low, volatility so compressed, if anything I would expect to see more worst-of than less. It has become a normal way to get premium when volatility is just not there.”

Andrew Valentine Pool, main trader at Regatta Research & Money Management, would not mind seeing fewer worst-of products.

“We’re very familiar with them. You’re trying to get into structured notes and you’re getting the worst deal. I can’t remember the last time we did a worst-of,” Pool said.

But he acknowledged that issuers face a dilemma as pricing premium becomes very challenging in a low volatility environment. Meanwhile investors want both exposure to equity and some form of protection.

“No one would argue that the market run is overextended and that we’re long overdue for some kind of correction,” said the sellsider.

“The catalyst could be a lot of things.”

Risk on

For some, investors’ complacency may just be one of such catalysts.

Last week’s top three offerings for instance featured notes with full downside exposure.

When not pressed to get more yield, investors take advantage of the low volatility to use leverage as a way to magnify return without any barrier or buffer.

“I think there is less focus on risk than there was three to five years ago,” said Pool.

“This has been especially the case as the most recent quarterly earnings have been very strong.

“The bull market has created a false sense of safety and people feel compelled to increase risk.”

Pool attributed the pricing of leveraged deals with full downside risk or the multiplication of worst-of products to investors’ complacency and willingness to take on more risk.

“It’s a mixed bag. You have that desperate quest for yield and also people don’t want to miss the rally ...it has investors move up the risk ladder faster than a few years ago,” he said.

Big commodities trade

The week ended Friday kicked off August. Volume was slim with $263 million in 90 deals. These figures may be upgraded due to filing delays. The previous week closed July with $1.80 billion in 448 deals, according to the data.

Exceptionally, commodities took precedence last week with BofA Merrill Lynch selling the top deal in this asset class. Its financing subsidiary BofA Finance LLC priced $47.7 million of 13-month floating-rate commodity-linked notes linked to the S&P GSCI Light Energy Index Total Return.

The payout at maturity is par plus 300% of the index gain. The notes pay one-month Libor minus 11 basis points. The notes are putable at any time and subject to a mandatory redemption if the index closes below 85% of its initial level.

Pool said that it made sense to see a large commodities offering, declining to bet on the asset class.

“When something is beaten up so badly as commodities have been, you’re going to see buyers again. So I wouldn’t be surprised if we saw more of those...I’m not saying now is the good time to buy. But it’s definitely better today than it was four years ago,” he said.

The sellsider said the offering must have been bought by an institutional investor.

“It’s not your retail kind of product. I can see from an institutional investor’s standpoint the rationale behind it. It’s an entity with a large exposure to that commodity or that may want to substitute some of it as a hedge.

“You can reduce your direct exposure by a third.”

Stock deal

About 20% of last week’s issuance volume came from notes linked to single stocks. The largest one was tied to a bank stock.

Citigroup Global Markets Holdings Inc. priced $24.84 million of three-year contingent income autocallable securities linked to the common stock of Bank of America Corp. Based on quarterly observations the notes pay a 9% a year contingent coupon based on an 80% coupon barrier. The automatic call is triggered at par.

The barrier at maturity is also 80%. Morgan Stanley Wealth Management is the dealer.

The other stock deal was Credit Suisse AG, London Branch’s $5 million deal linked to Delta Air Lines, Inc.

“We’re actually doing our own deal on Bank of America stock. It’s one of the bank stocks that have the most potential for volatility, so there is demand for it,” the sellsider said.

Long-term risk

Morgan Stanley was also the distributor for the third deal: Barclays Bank plc’s $13.54 million of 10-year contingent income callable securities linked to the S&P 500 index.

The notes pay a contingent quarterly coupon at an annualized rate of 7% if the index closes at or above its 75% coupon barrier on the observation date for that quarter.

The notes are callable at par on a quarterly basis as well.

The barrier at maturity is 60%.

“I like this one for the lower risk. Principal at risk on a longer-dated note is pretty limited,” the sellsider said.

“Of course your risk is on the coupon. They give you a low barrier at maturity but the coupon barrier at 75% is a little harder to achieve. You’d rather have it the other way around... A 75% principal barrier at maturity would be more than enough on a 10 year. And you would maximize your chance of getting paid at 60%.

“But if they did it that way, it wouldn’t price well. You have to take the risk on the coupon because that’s where the premium is on a 10 year. The risk of losing the interest payment adds more coupon.”

The top agent last week was BofA Merrill Lynch with two deals totaling $48 million, or 18.44% of the total. It was followed by Barclays and JPMorgan.

BofA Merrill priced its own two deals and led BofA Finance LLC to top the list of issuers.

“People are cautious, which leads them to consider structured products that have some hedging components built into them.” – A sellsider

“I think there is less focus on risk than there was three to five years ago.” – Andrew Valentine Pool, main trader at Regatta Research & Money Management

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