Week ahead of Fed announcement proves slow except for pricing of year's top commodity deal

By Emma Trincal

New York, Sept. 18 - Issuance last week revealed a tale of two markets. There was one big deal in excess of $100 million in the out-of-favor commodities asset class along with small deals of less than $15 million in size.

The two trends made for $300 million of total sales, which is weak by this year's standards, according to data compiled by Prospect News.

The market continued to rally with the S&P 500 finishing up 2% for the week. But excluding the top commodities deal, structured notes volume was unusually low, according to the data.

"I think the Fed tapering announcement has a lot to do with this. People have been sitting on their hands since June," a sellsider said.

The market was on hold last week as investors waited for the Sept. 18 Federal Open Market Committee announcement. This sellsider said that the "wait-and-see" attitude of investors "put other markets on hold, and not just structured products."

Agents priced 77 deals versus 96 the week before. Volume declined by 20% week over week.

Last week's volume was down 55% from $661 million in the week of Aug. 11, which was also the second week of the month.

Even with the top commodities offering, last week's $300 million volume put the week among the worst of the year - the weakest one was the week of June 30 with $180 million, and the best one was the week of June 23 with $1.85 billion, according to data compiled by Prospect News.

Top commodities deal

Barclays Bank plc priced the biggest commodities deal to date this year with its $103.38 million of 0% buffer enhanced notes due Sept. 29, 2014 linked to the Brent crude oil futures contract, according to data compiled by Prospect News.

The notes have a 15% buffer with a 1 1.1765% decline for every 1% decline in the underlying price beyond the buffer. The upside features return enhancement through a 5.47% contingent minimum return if the final price of Brent crude is greater than or equal to the 85% buffer level. Above that level, investors will participate in the upside up to a 15% cap.

Barclays was the agent with JPMorgan as the placement agent.

Commodities issuance more than doubled so far this month, but this is only the result of Barclays' deal. Between Sept. 1 and Sept. 14 and the same period last month, volume in this asset class grew to $125 million in six deals from $59 million in seven deals. Without the big Barclays deal, volume declined sharply. Commodities issuance is down nearly 30% year to date to $1.36 billion from $1.91 billion. Yet some market participants are not discouraged by the dearth of action in this asset class.

"The first half of the year has been pretty quiet in commodities, but it has picked up since July and August," Philippe Comer, managing director, head of commodities structuring-Americas at Barclays, told Prospect News.

"We've seen in particular upward pressure in the price of energy and oil since that time.

"As an example, Brent in the first half of the year was trading in the $87-$97 range. Starting in June, prices have gone out of the range; we broke out to the $100 level, and we're now in the $105-$110 range.

"Oil has also benefited from a steeper [futures] curve. Front ends [contracts] have gone up while the forwards have gone down. You're seeing now the front at around $105 while the forwards trade substantially lower. This gives you a pricing advantage as we're now in strong backwardation," Comer said.

Backwardation refers to the steep shape of the futures yield curve. When front months are more expensive than further dated months, it helps returns as contracts sell higher and cost less as they are being rolled into the next month.

The sellsider was skeptical that commodities could recover and reach their previous volume levels of last year.

"Goldman's Lloyd Blankfein was talking about that this morning on CNBC. Goldman is not very bullish on commodities, especially gold. They think that if interest rates move higher, it will make commodities prices more expensive, in particular for gold that doesn't pay any interest rates," the sellsider said.

The large oil-based offering that priced last week "made more sense" as crude oil fares better than most other commodities, he said.

"You can't throw commodities in the same bucket because each commodity is purchased for different reasons. Some like oil offer an industrial use as opposed to gold," he said.

Fed announcement

Structured products issuance could turn a new corner after the Fed announcement, the sellsider said.

"The Fed has telegraphed the tapering for months, creating initially a sell-off because people have anticipated a high increase in interest rates, which would have been negative for equities. Since then, a lot of people have been waiting on the sidelines. Here we are today," he said.

He spoke on Wednesday prior to the FOMC policy statement and chairman Ben Bernanke's press conference in the early afternoon.

"I expect the Fed announcement to be an extreme non-event. They will taper in a very moderate way, maybe $10 billion a month, and the impact on rates will be limited. People were expecting that rates would go much higher and that investors would be moving back to their normal allocation, putting money back into bonds to get better rates. That's not going to happen.

"All investors across all asset classes have been sitting heavily on their hands since June. It wasn't so much the case with equities, which rallied in July and again this month. But that's also because equities were extremely under-owned ever since 2009. It had the lightest weight. It was easier to find a reason for them to go up.

"In the post-tapering announcement environment, people are going to realize that they won't be able to take the cash and reallocate it safely while earning better rates. It will be a huge non-event and a good one for structured products issuance. People will go back to the drawing board. They'll say, 'I have to look for other alternatives to get higher yield and enhanced returns,' and that leads them to consider structured products. So I'm pretty optimistic."

Pricing and demand

The impact of higher rates, if any, would depend on the increase itself but also on the kind of deals to be structured, a market participant said.

"It's not clear cut. You can't say it's going to help all the deals. For instance, you would think the steepeners would benefit from a rise in interest rates. But those steepeners are not just a play on interest rates. They're also a play on the shape of the curve. A rise in interest rates would help in one way, not in the other way.

"What an increase in interest rates would definitely help are principal-protected structures.

"Higher rates usually help the terms. You're always forgoing money that you could have put in a simple bond. So when you compare the better terms you get from your structured note with the higher rates offered by a bond, it's not necessarily clear which way you would want to go."

Some sources said that an equity sell-off could follow should the Fed decide to cut its asset purchases too drastically. Others anticipate a surge in volatility in September due to upcoming battles in Congress and possible risks in Europe. The market participant said that the impact of rising volatility on structured products volume is also neutral as the answers are not clear.

"If volatility goes up, it helps equities. If you're looking at a cap, the higher the volatility, the higher the cap. You can get lower barriers as well, and issuers can make a deal more attractive," this market participant said.

"However, it's hard to say if the volume of sales will increase because volatility also comes with fear, and people will worry more about the risk. You can have a lower barrier, [and] if the volatility is high, the barrier can be breached more easily. This is why those pricing factors are not necessarily helpful in predicting volume trends. It's hard to know whether the attractiveness of the terms will offset investors' reluctance to take more risk or vice versa."

Top deals

Last week, investors did not shy away from risk, bidding on single-stock offerings, which made for 30% of the market versus 14% for equity indexes, the data showed.

The majority of those products used the increasingly popular autocallable reverse convertible structure, which last week accounted for more than 30% of the volume in 25 deals. In comparison, leveraged structures with or without buffers or barriers amounted to only 12.5% of the volume.

The top autocallable reverse convertible linked to a stock and the No. 2 offering of the week was brought to market by UBS AG, London Branch with its $15 million of contingent income autocallable securities due Sept. 16, 2016 linked to Cobalt International Energy, Inc. shares.

The notes pay a contingent quarterly coupon at a rate of 18% per year if Cobalt stock closes at or above the 60% downside threshold level on the determination date for that quarter.

If the shares close at or above the initial stock price on any of the first 11 quarterly determination dates, the notes will be called at par plus the contingent coupon.

If the notes are not called and Cobalt stock finishes at or above the 60% trigger level, the payout at maturity will be par plus the contingent payment. Otherwise, investors will be exposed to the stock price decline, payable in shares or cash at the issuer's option.

The third largest deal was the only rates-linked offering of the week. Citigroup Inc. priced $11 million of callable leveraged CMS spread notes due Sept. 18, 2033 linked to the 30-year Constant Maturity Swap rate and the two-year CMS rate.

The first-year interest rate is 10%. After that, it is four times the modified CMS spread, subject to a minimum interest rate of 0% and a maximum interest rate of 10% per year. The modified CMS spread is the 30-year CMS rate minus the two-year CMS rate minus 25 basis points. The payout at maturity will be par.

The fastest-growing structure for the year is autocallable reverse convertibles. Their volume has increased by 82.5% to $4.39 billion from $2.41 billion.

Rate-linked note offerings have seen their volume more than triple to $929 million from $289 million, according to the data.

Equities were up nearly 5% with single-stock issuance increasing by nearly 17% to $5.85 billion while equity indexes volume remained flat at $14.54 billion.

Barclays was the top agent last week with $114 million sold in 11 deals, grabbing 38% of the market. The second agent was UBS with 29% of the volume followed by Morgan Stanley with about 11%.

"People have been sitting on their hands since June." - A sellsider

"It's not clear cut." - A market participant about the effect of higher rates, if any

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