Market sees flurry of callable reverse convertibles during slow week; yearly volume up 2.31%

By Emma Trincal

New York, Aug. 28 - Last week was a typically slow summer week, but sources noted an unusually large bid for autocallable, or sometimes just callable, reverse convertibles.

Only $376 million priced in 93 deals, a 43% decrease from the prior week's $661 million, according to data compiled by Prospect News.

Volume for the year to date as of Aug. 24 rose 2.31% to $23.58 billion from $23.05 billion during the same period last year, according to the data.

Similarly, August so far is showing an encouraging uptick, growing 27% to $1.47 billion from $1.16 billion during the same period in July. The month compared to a year ago showed a 3.92% increase from $1.41 billion in Aug. 1-24 of last year.

"We're seeing much more activity," a sellsider said.

"Look, it's the end of August. You would expect a lot of people to be on vacation. But we're seeing more action, more requests for quotes, a greater variety of different structures. It bodes well for what's to come in September."

"The holidays are over," a structurer said.

Still bullish

The market painted a mixed picture last week with the Nasdaq blackout on Thursday and reports of possible strikes in Syria, but overall the S&P 500 finished the week flat and the CBOE Volatility index declined in the later part of the week.

"We have a geopolitical stress around Syria, but we think the correction will be short-lived, at least if the crisis remains confined to Syria. Oil prices are probably not going to move much higher, especially with oil production going up in the U.S.," the structurer said.

"In the meantime, this choppy period is an opportunity to enter the market. We're seeing short-lived increases in volatility depending on the stock, the index, the maturity. Based on investors' risk tolerance, you're seeing volatility surges on a case-per-case basis that should be exploited as opportunities.

"But in the meantime, volatility remains low and market sentiment continues to be bullish even with the uncertainty around Syria.

"The Fed and the ECB have indicated that an increase in rates is not going to happen before 2014. We've already seen much of the tapering priced in. We have low spot yields on the Treasury curve, but the forwards are showing the steepest curve we've ever seen.

"We have a recovery probably everywhere. Investor sentiment continues to be bullish. Even Japan has leading indicators that are positive. Sooner or later we are going to exit this crisis, and we don't think the macro picture should change."

With the market still on the uptrend, low volatility levels continue to be a pricing challenge for issuers, he said.

This may be one of the reasons for the surge in autocallable reverse convertibles, he noted.

Those structures amounted to 55% of last week's volume, according to the data, a high market share compared to the yearly average of 17%.

Leveraged structures, which tend to dominate, were second, amounting to 26% of the volume versus a year-to-date average of nearly 40%. Within this category, most leveraged products offered a barrier or a buffer.

Accelerated return notes with full downside exposure were crushed - they totaled only $2 million in two deals. On a year-to-date basis, unprotected leveraged deals make for more than 20% of the volume.

Autocallable reverse convertibles

"Autocallable structures are a way of increasing the coupon from an optical point of view when there's not much volatility in the market," the structurer said.

"You actually sell the rights to a good performance, so you get a premium for that. As long as the market doesn't move above a certain level, usually the initial price, the structure continues to pay a coupon.

"Say you have a 10% per annum which you can collect in theory every three months as a 2.5% coupon. There's a very small chance of getting this 10%. To get the full premium, the notes must not be called. It's unlikely. The notes must not be called, which means the structure must go against you - toward the barrier - but above the barrier without hitting the barrier. That's why you get attractive yields on those products."

Call or autocall options applied to reverse convertibles have been a way to overcome the challenge of pricing this traditional structure, which has progressively vanished from the market, he added.

"When volatility is low, coupons tend to melt. Anytime you sell volatility on a non-callable product - reverse convertible, barrier reverse convertible, worst of, etc. - your yield is not going to be very exciting. That's why you're seeing an outpouring of autocallables," this structurer said.

Call versus autocall

The top deal last week was callable.

JPMorgan Chase & Co. priced $50.35 million of contingent coupon callable yield notes due Aug. 28, 2017 linked to the S&P 500 index, the Russell 2000 index and the iShares MSCI EAFE index fund.

The contingent coupon is 8% per year, and the coupon barrier is 60% of the initial price observable quarterly. The coupon is paid if all three underlying components are above the 60% barrier on the observation date.

The notes are callable at par on any interest payment date other than the maturity date.

The payout at maturity will be par unless any underlying component finishes below its barrier level, in which case investors will get a return equal to the decline of the worst-performing component from its initial level.

"Callable deals will always be worth more than autocalls because you sell the issuer the right to redeem at any time," the structurer said.

"I don't see a lot of those in the equity space because people don't like the uncertainty. The call depends too much on the goodwill of the issuer. They can call the notes even if it's slightly negative if they expect to pay a coupon on the next interest payment date.

"But given the size of this one, people probably found the terms attractive.

"I still think that one should calculate the difference between a call at the discretion of the issuer and the autocall to see if it's worth giving the issuer discretion over the call. It would be very difficult to tell of course. You almost would have to ask JPMorgan to price the two deals. But people need to know that they get better terms for a reason."

The sellsider agreed.

"Autocalls are different from regular calls. Autocalls are simpler. You know exactly at what level the call is going to be triggered. With a call, you don't know that, but in exchange for the uncertainty you get better terms."

Morgan Stanley

Among the top six offerings that priced last week, all the other contingent coupon deals were distributed by Morgan Stanley.

Morgan Stanley Smith Barney was the dealer on the third deal, which was brought to market by UBS AG, London Branch. It was $34.52 million of contingent income autocallable securities due Aug. 26, 2016 linked to Bank of America Corp. shares. The contingent quarterly coupon is 8.1% per year. The barrier for the coupon is 80% of the initial price. The call strike is the initial stock price.

If the notes are not called and Bank of America stock finishes at or above the 80% downside threshold level, the payout at maturity will be par plus the contingent payment.

Otherwise, investors will incur a loss equivalent to the decline of the stock from its initial price and will get paid in either cash or shares.

Other Morgan Stanley-distributed autocallables followed as the fourth, fifth and sixth largest deals.

The No. 4 deal was issued by Morgan Stanley itself in its $23.64 million of contingent income autocallable securities due Aug. 29, 2016 linked to Ford Motor Co. shares with a 9% annualized coupon and a 75% downside threshold.

The fifth offering, also tied to a single stock, was brought to market by Royal Bank of Canada in its $14.51 million of contingent income autocallable securities due Aug. 28, 2014 linked to the common stock of Facebook, Inc. The annualized coupon is 13.15% and the downside threshold, 75%.

Finally, the No. 6 deal, this time linked to equity indexes, was UBS' $12.86 million of autocallable securities due Aug. 23, 2018 linked to the worst performing of the Euro Stoxx 50 index and the Russell 2000 index.

A total of 44 autocallable or callable reverse convertibles priced last week, but only five of them had a size in excess of $10 million, according to the data.

"I think that autocallables with a contingent coupon are popular right now for a couple of reasons," the sellsider said.

"It's a way to increase the coupon, that's number one.

"Number two, investors believe it's likely to be called, so it shortens the maturity.

"For someone who normally has a one to two years horizon, going into a four year with the expectation to be called after one year seems to make sense."

The second largest deal was a leveraged buffered note.

Morgan Stanley priced $41.17 million of buffered Performance Leveraged Upside Securities due Aug. 22, 2016 linked to the Euro Stoxx 50 index.

The upside offers two-times leverage up to a 45% cap. There is a 10% buffer on the downside.

The top agent last week was Morgan Stanley with $86 million in 12 deals, a 22.93% market share. It was followed by JPMorgan and UBS.

"We're seeing more action, more requests for quotes, a greater variety of different structures." - A sellsider

"Callable deals will always be worth more than autocalls because you sell the issuer the right to redeem at any time." - A structurer

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