Bid for unprotected leveraged notes, autocallables goes on as equity markets set new highs

By Emma Trincal

New York, May 8 - Volume was muted last week as May kicked in, with inconclusive trends appearing early on in the month.

But year-to-date data compiled by Prospect News showed that investor appetite for structured notes has focused on two types of structures: leveraged notes with full downside exposure and autocallable reverse convertibles, often called "phoenix."

Agents sold $412 million in the week ended Friday in 98 deals. The prior week of April 21 was the effective pricing week of that month, with $1.17 billion priced in 264 deals.

For the year, $12.69 billion notional amount of notes were sold in 2,715 deals as of Friday. It was a 5.1% decline from last year's $13.38 billion in 2,973 deals.

"We had our weekly managers' call on our trading desk for all fixed income and we looked at the stats for the last two months of April. In both 2011 and 2012, April was a relatively slow month bracketed by the busiest months of February and March and a pickup again in May and June," a structured products sellsider said.

"The only thing we could come up with is that April is tax month. People are more concerned with tax planning than investing.

"This period of the year is somewhat cyclical. We'll see if volume picks up later this month. It's a little bit early to call May slow. Our busiest week is the last week of each calendar month, so we're not there yet."

Jim Ziniel, former marketer of structured notes, said that the year-to-date volume could be worse.

"We're down 5% for the year. It's not a drastic decline. The main factor is the very low volatility environment. The VIX has been below 15 for the most part in the last six months. As a result, deals are not pricing very well. But you're still getting big institutions behind these trades propping up the sales, and that's why we're only down 5% for the year," Ziniel said.

Stocks

The volume of single-stock issuance rose last week while index products declined.

Agents sold $169 million of single-stock-linked notes offerings, a 22% increase from the prior week, which was a busy one. Separately, equity index notes fell 86% last week from the prior week to $122 million. Unusually, stocks made for a greater portion of the total at 41% versus 30% for equity indexes.

"One of the things driving single-stock issuance as opposed to indexes is confidence," Ziniel said.

"When market sentiment rises, people are more comfortable assuming market risk.

"In addition to that, a lot of these deals are done by private banks. Those carry a lot of weight. The sales environment would be down a lot more if it was not for private bank business. It would be substantially lower if you took it out of the equation."

Ziniel noted that the increased bid on stocks earlier in the month may be due to the calendar.

"Index deals tend to be calendar-based while stuff at the beginning of the month may be more of a tactical situation trade," he said.

"The market rally contributes to the appetite for specific equities. As stock prices rise, investors tend to be more bullish and less risk-averse. A lot of the time, it's driven by the research of the institution. They know there's a momentum around certain names and they price deals accordingly."

Phoenix

Another trend last week, probably related to the prior one, was the significant presence of autocallable reverse convertibles, making almost a third of the total at 31%. Those products tend to be linked to either single stocks or exchange-traded funds. Sales in this structure type reached $126 million. It was the only category of products not to show a decline (volume was flat) compared to the prior week.

Those notes usually offer a contingent coupon - unlike the fixed interest in a standard reverse convertible - and are callable if the underlying price on the observation date is above a specific threshold, usually the initial price. The coupon is payable when, on the observation date, the underlying is above a lower strike or trigger level. The trigger level at maturity often serves as a final-day barrier to determine repayment of principal.

"We see a pickup or maybe a shift there because volatility on single names has come in quite significantly. In order to keep the yields where you want them to be, you have to add something to the notes," the sellsider said.

"That's one of the reasons we've seen this shift from straight reverse convertibles into autocallables or phoenix autocallables. It adds uncertainty, but it also gives you more leeway in the pricing. You can use these features simply to add to the coupon or to add to the protection; it works either way. Those increasingly popular products are just another way to create more viable solutions in this low-volatility environment. So we see a shift from what used to be reverse convertibles into phoenix notes. It's a pretty visible trend."

An example of this product was JPMorgan Chase & Co.'s $20.42 million of contingent income autocallable securities due May 2, 2014 linked to the Market Vectors Gold Miners exchange-traded fund.

While small in size, the offering was the third-largest deal of the week as only three deals in the $20 million or more size bracket were priced, compared with 11 during the week before, according to the data.

The notes paid a contingent quarterly coupon of 3.5% if the fund closed at or above the 75% downside threshold level on the determination date for that quarter.

If the shares closed at or above the initial stock price on any of the first three quarterly determination dates, the notes would be called at par plus the contingent coupon.

If the notes were not called and the fund finished at or above the downside threshold level, the payout at maturity would be par plus the contingent payment. Otherwise, investors would be fully exposed to losses.

For the year, autocallable reverse convertibles have become the No. 2 structure with a 17.16% market share. Their volume increased by nearly 90% from the week before.

However, the appeal of single stocks as seen last week is not a yearly trend. In fact, their volume has decreased by 2% from the prior year versus a slight 4% increase in equity index issuance. Those numbers remained inconclusive, sources said.

Riding the bull

The rise in leveraged notes with no downside protection is this year's second big trend, according to the data.

Those have doubled in volume year to date to $2.76 billion. They now represent the top structure sold so far at 21.77% of the total in 208 offerings.

In comparison, leveraged notes with either a buffer or a barrier are down in volume by 24% and make for 16.67% of the total.

The sellsider shared a conversation he had with a sales representative using these structures.

"One of those reps had an interesting take on it," he said.

"He was using leveraged notes with no downside protection to actually reduce risk in the portfolio. The idea was to swap out of a direct exposure to the underlying into a different allocation: half in cash and half in an investment into the leveraged note.

"Now he's got half the downside risk he used to have with the cash while keeping the same upside exposure with the two times leverage, assuming that the cap that he gets meets his target return. Obviously he's capped. But notes with no downside protection tend to have higher caps, so he may be able to meet his target without too much difficulty.

"Effectively, he has the same upside exposure and he is protected on the downside at 50%. For someone who wants to continue to ride the rally but who is worried about a sell-off, here's a way to stay invested with less risk.

"It's a little bit like buying a call option, which would cost you far less than buying the stock, but at the same time, would also reduce your amount of capital at risk.

"The use of those non-protected leveraged notes is a form of a hedge. It's a tool to achieve risk reduction, which I think should be one of the primary reasons for people to invest in structured products. The idea is to adjust downwards your risk profile. And if you use those notes in that way, you can reduce your risk while getting a chance to let your winners run."

Stock market averages reached new highs last week on strong jobs data Friday, and investors have expressed the need to "let their winners" win while protecting their portfolio somehow, he explained.

"You don't want to stay away from the market that's trending higher. This strategy is a way to stay in it with some protection and less downside exposure," he said.

For Ziniel, pricing was a contributor to the trend.

"There is an appetite for unprotected deals. I see two drivers behind it," he said.

"First, clients and advisers are more comfortable assuming more equity risk given the momentum in the market.

"Second, low levels of volatility don't allow you to get the buffers or even barriers you would have had one or two years ago.

"From a risk return perspective, it may make sense to assume the risk and have leverage on the upside versus severely limiting your upside for some unappealing protection.

"It's consistent with the market cycles. When you see the market getting stronger, you want to raise or eliminate your cap and get some returns."

The top agent last week was Morgan Stanley, which sold $101 million in 11 trades, or 24.58% of the total. It was followed by Credit Suisse and JPMorgan.

Credit Suisse was the agent for the top deal, Credit Suisse AG, Nassau Branch's $37.95 million of 8% equity-linked notes linked to Gilead Sciences.

Morgan Stanley issued the second offering with its $22.6 million of 0% buffered Performance Leveraged Upside Securities due Oct. 30, 2015 linked to the S&P 500 index.

"The main factor [behind the volume decline] is the very low volatility environment." - Jim Ziniel, former marketer of structured notes

"The use of those non-protected leveraged notes is a form of a hedge." - A sellsider

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