Last week saw hectic headlines but low volume; sales down 26% compared to March

By Emma Trincal

New York, April 24 - The U.S. structured products market was subdued last week with $195 million sold in 73 deals despite the headline-heavy week being marked by more volatility than usual due to the Boston Marathon bombing.

The top-selling structures were leveraged notes with barriers or buffers as well as autocallable reverse convertibles, according to data compiled by Prospect News.

Sales were down 63% during the third week of the month ended Friday compared to the previous week's $528 million, the data showed.

Volume dropped 26% to $1.01 billion for the month to date compared to $1.37 billion in the period of March 1 through March 20.

Overall, agents have sold $10.94 billion year to date, a 5% decline from the same period last year, during which $11.52 billion of notes were issued.

The number of deals has fallen nearly 10% to 2,319 from 2,561.

The data does not include exchange-traded notes or large plain-vanilla fixed-income rate deals such as fixed-to-floating notes, step-ups, step-downs and capped floaters.

Based on current information from Securities and Exchange Commission filings, last week was the weakest of the year, immediately followed by the first week of April.

Cap allergy

Some believe the current equity rally may have an impact on investors' psychology when looking for growth.

"One part of the market is based on growth. You get a buffer plus some leverage plus a cap. These are the most popular structures. They're usually appealing to investors who expect single-digit growth," a sellsider said.

"But the market has had a very strong run so far this year. The S&P 500 is already up 10%. The market performance is so strong that maybe we're seeing a gradual change in thinking. Maybe investors are not so excited anymore about having a cap because they perceive it as a limit on their returns compared to what they could get if they had a direct exposure to the market.

"Such change in the psychology could in some way explain the lower volume."

Leveraged notes with partial downside protection (buffer or barrier) were the No. 1 structure last week with 37% of the total. Their share as a percentage of the total was 23% for the month, and the volume seen in this category on a month-to-month basis grew at a rate of 30% to $231 million. However, for the year, this structure type has seen its volume decline by 22%, according to the data.

Volatility neutral

A structurer said that the success of leveraged notes with buffers or barriers was related to how well the structures fit with the current pricing environment.

"With volatility so subdued - it rose last week [but] has come back down again - it's just hard to find structures that price well right now," this structurer said.

Last week's bombing in Boston caused volatility to spike. The CBOE Volatility index, or VIX, started the week at around 12 and rose to about 17 on Monday in reaction to the news. It surged again to 15.5 on Thursday and finished the week below 14.

"Volatility spiked last week, but it was on such a short time," the structurer said.

"It takes people a couple of weeks to price and market their offerings. You need a couple of weeks of elevated volatility levels to take advantage of pricing. It has to remain high during that time.

"Besides, the VIX is not a good indicator. It's very short-term. Most structures are one to two years long, and there is not much of volatility there," he said.

Sources did not attribute the low volume seen last week to the headlines.

"There was a short spike in volatility last week due to the Boston Marathon. Maybe it kept people away from the market, but I don't think it was a fundamental factor. However, it may have created some significant distraction," the sellsider said.

"This week, most people are closing their offerings for the month, and we'll see what happens at the end of the month."

The largest deal employing leverage with partial downside protection last week was JPMorgan Chase & Co.'s $13.9 million of 0% buffered return enhanced notes due May 7, 2014 linked to the MSCI EAFE index. The leverage factor was 1.5 times with a 10.65% cap. The buffer was 10% with a downside leverage factor of 1.1111% beyond the buffer. It was the week's second-largest offering.

Last week only saw six deals in the $10 million or more size and only one at $20 million.

"Leveraged buffered notes are more resilient to low volatility. They're almost volatility-neutral structures. And that's why they work in this environment," the structurer said.

"You're doing a call spread and you're selling a put, and the two cancel each other out.

"The pricing of those deals is less sensitive to volatility than other structures. That's why no matter what the volatility environment is, these products will always do well.

"They also make sense for investors. The market has had a good run. Investors may want protection on the downside. But they also want the leverage on the upside because they think they've missed out on the upside.

"Those structures are simpler, they're appealing, and they are less sensitive to volatility. All those factors explain why they're almost always the best-selling products."

Autocallable reverse convertibles

The second best-selling category of deals last week was autocallable reverse convertibles, which accounted for 20.5% of the total with $40 million in 25 deals, according to the data.

Typically, those products pay a contingent quarterly coupon when the underlying closes above a trigger set at a lower price than the initial price. If the underlying closes above the initial price on the observation date, the notes are called and investors get their last coupon. When notes are not called, investors at maturity get par if the underlying closes above the trigger, otherwise they lose in the same proportion as the underlying decline.

The structurer explained that the success of callable reverse convertibles was also the result of current pricing challenges and represented issuers' efforts in finding solutions.

"With a simple reverse convertible today, you need to go further out in maturity in order to get the same coupon you used to have earlier. People don't like that," the structurer said.

"So issuers still structure the long maturity, but they introduce the callable feature, which gives investors some kind of chance of early redemption. That's why those structures are very successful.

"Investors know that they may have to hold the notes for two years, but they hope to be called, they hope to get their money back sooner. You have a bit of return with the possibility of having a short-term product."

For the year, autocallable reverse convertibles represent almost 17% of the total with $1.83 billion in 696 deals. They have nearly doubled in volume from $974 million last year, according to the data.

"When you think of the market, you're still seeing two major trends: the search for yield and the need for growth," the sellsider said.

"In this part of the market where people are looking for higher coupons, you're seeing growing demand for those callable reverse convertibles. Investors are OK to potentially extend maturities. You're seeing other types of yield-enhancement products, more steepeners or fixed-income type of structures with a variable coupon based on the shape of the curve. All these are solutions to the need clients have to generate yield.

"As interest rates continue to remain very low, it's more difficult to create these products. But on the other hand, there aren't a lot of alternatives. So those instruments continue to attract the attention of clients."

An example of a fixed-income structure linked to the shape of the rate curve was the No. 1 offering of the week: JPMorgan priced $20 million of fixed-to-floating-rate leveraged CMS curve and S&P 500 index-linked notes due April 30, 2028. Investors received a 7% fixed coupon for the first two years. After that, the coupon became variable and defined as four times the spread of the 30-year Constant Maturity Swap rate over the five-year CMS rate, up to a maximum annualized rate of 7%, for each day that the index closed at or above the 75% barrier level. The payout at maturity was par.

Commodities remained a weak asset class but rose in volume last week due to the pricing of a larger deal, the week's third-largest issue in size. It was the only asset class to see an increase in volume, up 5% from the prior week.

Citigroup, Inc. priced $12.2 million of floating-rate notes due May 23, 2014 linked to the Dow Jones-UBS Precious Metals Total Return sub-index.

The interest rate was one-month Libor minus 19 basis points. Interest was payable monthly.

The payout at maturity was par plus triple the sum of the index return minus the Treasury bill amount minus a fee.

The notes were putable in whole at any time and callable if the index closed at or below 85% of its initial level.

The top agent was JPMorgan with $54 million, or 27.45% of the total, in 10 deals. It was followed by Goldman Sachs and UBS.

"The pricing of those deals is less sensitive to volatility than other structures. That's why ... these products will always do well." - A structurer on leveraged buffered notes

"The market performance is so strong that maybe we're seeing a gradual change in thinking." - A sellsider

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