Despite extreme spike in volatility, reverse convertible sales remain feeble in slow week

By Emma Trincal

New York, Aug. 10 - The structured products market was slow to respond to an unprecedented spike in volatility last week, as suggested by the anemic volume of reverse convertibles printed during a week centered on the debt ceiling deadline followed by a market correction the likes of which haven't been seen since 2008.

Last week saw the VIX index, an indicator of volatility, rise 40% to 32 at the end of the week from 23 on Monday. The Dow Jones Industrial Average lost 688 points from Monday to Friday.

"The last two days were probably the most volatile consecutive days in history. One day people are selling, the next, they're buying," said Michael Iver, former structurer at JPMorgan.

"You may expect to see more reverse convertibles next week, but you always need to leave room for surprise."

Solid month, year

As expected for a new month, issuance of all products declined by 80% to $389 million in the week ended Aug. 5 from $1.87 billion in the last week of July excluding exchange-traded notes, according to data compiled by Prospect News.

On a month-over-month basis though, volume in the first week of August jumped 50% from the $260 million sold in the first week of July.

The year is already beating last year's volume with $27.27 billion so far compared to $24.23 billion priced during the same period of 2010, a 12.5% increase.

"It's a healthy pick-up, and that's good. It doesn't surprise me. It shows that structured products are resilient," a market participant said.

"I also see higher volumes anecdotally within my organization. It's very encouraging for the industry."

Equity deals dropped week-over-week, but on a monthly basis, their volume grew by 65% to $321 million, or 82% of the total, from $194 million, or 75% of the market.

VIX term structure

What surprised some was the weak volume of reverse convertible issuance, which fell 91.5% to $28 million from $336 million sold in the last week of July.

Investors in reverse convertibles are in a position equivalent to shorting volatility. As a result, reverse convertibles tend to do well when volatility spikes as the coupons are more attractive.

But obviously this type of product did not benefit from the opportunity offered by the market last week.

Iver said that the calendar was the first obvious reason.

"The first week of the month is always the slowest," he said.

In addition to that, he offered an explanation based on the difference between short- and longer-dated volatility contracts.

"You can't look at the short-dated VIX alone to understand where issuance is going to go," he said.

"There are different types of volatility playing out here.

"You have the VIX spot. It's an index, and you can't buy it. And it's a very short-dated index. It's 30 days.

"Then you have the realized volatility, a huge move last week.

"You also have the VIX futures, which are longer-dated volatility contracts. Those matter the most when it comes to reverse convertibles because the deals are priced off those longer-dated contracts.

"You have the term structure, the difference between short- and longer-dated contracts.

"And finally you have the volatility of volatility, when the market goes up and down and up and down."

Pessimistic consensus

Iver said that one reason why reverse convertibles didn't pour into the market last week is because longer-dated contracts did not rise as much as the VIX.

"Last week the VIX shot up by much more than longer-dated VIX contracts," he said.

"Uncertainty was greater around the outcome of the debt ceiling deal, which was expressed in the VIX, a headline risk indicator.

"The VIX futures didn't go up by as much. The VIX futures didn't double.

"The whole term structure was twisted."

His explanation is that there is a pessimist consensus on the part of investors for the longer-term economic outlook. In the short term, though, the debt ceiling crisis created much more uncertainty.

"The VIX surged, reflecting the headline risk about one event on the calendar on August 2," he said.

On the other hand, he said, the longer-dated VIX futures tended to show a more convergent view.

"There is a lot of inconsistency in the economic data. Every forecast is different. The result is that everybody is pessimistic and you have a consensus around that," he said.

"The long-term volatility is lower because people have a consistent outlook on the world, albeit a negative one.

"It's the disagreement that creates volatility, and last week saw a lot of uncertainty around the debt ceiling.

"Ironically, everybody seems to agree that the economic outlook looking forward is negative."

The power of habits

The impact of well-established sales and investing habits was also an explanation for the weak volume of reverse convertibles, according to the market participant.

"Decision-making is more driven by people's behavior than by the market," he said, commenting on the lackluster volume of reverse convertible sales last week.

"To me, it has more to do with the calendar.

"Just because the market has movements, it doesn't mean that people's habits are going to change.

"And I'm not just talking about the banks and the brokers, but also the investors.

"People have an agenda. They're used to talking to their broker at the end of the month.

"Deals have a marketing period. During the month, you get people's interest and you accumulate their interest. At the end of the month, you price the deals."

Another factor was risk aversion, the market participant said, which has already played a role in the declining trend of reverse convertibles over the past couple of months.

Even if issuers have enough time to structure reverse convertible notes, they may not find the buyers easily when fear prevails.

"Investors may stay away from investing in reverse convertibles until the market settles down," he said.

"You don't want to catch a falling knife. It makes sense for many to say 'Let me think about it.'"

Top deals

Equity indexes represented nearly half of last week's issuance. Five of the top six deals were linked to the S&P 500 index.

The No. 1 deal was Barclays Bank plc's $54.76 million of 0% notes due Feb. 8, 2013 linked to the S&P 500 index. The payout at maturity will be par plus the greater of the index return and a contingent minimum return of 5% as long as the index closing level remains at or above a 75% barrier level during the life of the notes. The deal was sold by JPMorgan.

The second largest deal - also based on the S&P 500 - was JPMorgan Chase & Co.'s $40 million of 0% return enhanced notes due Aug. 21, 2012 featuring triple leverage capped at 20.61% and full downside exposure.

The third largest deal was linked to a single stock and was brought to market by Bank of America Corp. under its STEP Income securities structure, which has proven to sell very well.

The bank priced $38.65 million of 9% STEP Income Securities due Aug. 20, 2012 linked to the common stock of Citigroup Inc.

In addition to interest, investors will receive at maturity an additional 8.03% if the final price of the stock is greater than or equal to 109% of the initial price. Investors will get par if the stock finishes between 100% and 109% of the initial price and are fully exposed to losses if the stock is down at maturity.

JPMorgan tops

JPMorgan was the top agent for the week with $133 million sold in 12 deals for 34.19% of the total.

It was followed by Deutsche Bank with $53 million and by Goldman Sachs with $45 million.

JPMorgan is also the No. 1 agent year to date with $5.4 billion sold as of Aug. 5. It is followed by Bank of America Merrill Lynch with $4.66 billion.

"You can't look at the short-dated VIX alone to understand where issuance is going to go." - Michael Iver, former structurer at JPMorgan

"You don't want to catch a falling knife." - A market participant on why reverse convertible issuance is down

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