Week posts one of year's smallest totals despite $72.5 million synthetic convertible deal

By Emma Trincal

New York, May 21 - Agents last week sold $376 million in 99 deals, a 16% decline in sales from the prior week, according to data compiled by Prospect News.

It was the fourth weakest week so far this year, the data showed.

The pace would have been worse without a $72.44 million deal that featured an unusual structure mimicking a convertible bond, which sources said was likely to be a reverse inquiry from a large investor.

Slow May

For the month as of Friday, volume had fallen 22.5% to $1.0 billion from $1.3 billion during the same period in April.

"We're still combatting some of the issues that the industry has been combatting: a low-volatility regime and a low-interest-rate regime. Between the two, it's hard to give very compelling characteristics for the trades, but the issue is the same in the overall market," said Joseph Halpern, chief executive officer of Exceed Investments.

"People are looking for yield. People are chasing performance. You see more notes with no real downside protection."

However, volume this year has grown by 15.5% to $15.77 billion from $13.65 billion, the data showed.

The big picture

"It's a good thing for the industry that we're up year over year. Fifteen percent growth is not bad. It's a testament to the benefits structured products offer to clients," Halpern said.

But a structurer was more pessimistic.

"We should be up for the year, and we are up 15%. But I think we should be up more than that. Structured products should achieve a much stronger growth in order to become a real alternative to other asset classes," this structurer said.

"We can pat ourselves on the shoulder, but much more needs to be done to create products that attract the attention of investors."

For May alone, however, it may be too soon to be pessimistic, he added.

"It's not calendar-driven yet. It's still the beginning of the month. Until we get past the holidays, we can't blame it on the calendar," he said.

"It's really more about the enthusiasm of the investors and whether there are compelling products available in the market. That's the big picture."

Part of the big picture, the structurer said, is the market itself. After returning 32% last year, the S&P 500 index has only gained 2% so far this year.

"There is no major theme in the market," he said.

"We obviously had a tremendous year last year. Investors were excited in the first few months of 2014, but it's already the fifth month since the beginning of the year and the market hasn't really moved. It may have dampened the enthusiasm a little bit.

"You have a combination of two things: the enthusiasm is not there and at the same time, products overall are not compelling enough for investors to pull the trigger.

"We still see a lot of cash sitting on the sidelines. Investors are trying to have allocations, but there are no major allocations.

"People don't want to miss the potential rally, so they refuse some of the typical capped structures. But since there are no major compelling themes, a lot of investors are just content to stay out of the market and see what happens."

Synthetic convertible

The largest deal last week was not the typical structured product, but its size caught the market's attention.

Barclays Bank plc priced $72.44 million of synthetic convertible notes due May 20, 2012 tied to Freeport-McMoRan Copper & Gold Inc. The payout at maturity will be the greater of par and an alternative redemption amount, which is par times the final stock level divided by threshold level, which is 117% of the initial share price.

The issuer called the notes "synthetic convertible[s]" even though the product is more of a structured note with principal protection than an actual convertible bond, said Halpern.

But the structurer said such products could be seen as a substitute for a convertible bond.

The idea behind those deals, he said, is to offer a company an alternative to issuing a convertible bond by having an investment bank issue an equivalent instrument.

"In a regular convertible, the issuer - in this case, it would be Freeport - will issue bonds that pay a lower coupon, but at maturity, the bond can convert into shares if the share price increases to a certain level. The Barclays notes offer something similar. I don't think they're designed for the typical structured product buyer," the structurer said.

"The reason you have these deals is because the company may not have issued convertible bonds or they may have issued some that have sold out. So the company would ask Barclays to issue something that would mimic a straight convertible.

"It's also a way to offer bond buyers a better credit than what they would get with the company itself."

Freeport-McMoRan is rated BBB by Standard & Poor's versus A for Barclays.

Innovative dividend swap

Halpern noticed some differences between the structured product and a synthetic convertible.

"I wouldn't say it's a synthetic convertible, although that's how they call it," he said.

"A convertible usually pays an interest rate. This one doesn't. Instead they use the interest to provide investors with participation at a certain level."

A convertible bond would offer a yield and a strike level where the bond could be converted into equity, he explained. The yield would be lower than the market rate of the issuer due to the cost of providing the option.

"Ultimately, this looks more like a protection vehicle than a convertible vehicle," he said.

"Unless Barclays defaults, they provide 100% of your capital back. You don't get a coupon. But in return, they're giving you 117%, a higher threshold than par."

The large size of the deal was probably the result of several factors, sources said. For Halpern, the innovative nature of the structure made it clear that the deal was a reverse inquiry from a sophisticated investor. The structurer said that the client was likely to be an institutional investor, probably an asset manager.

"Another interesting element which makes me think the deal was customized for one person or one group is that they have incorporated some sort of dividend swap," Halpern said.

"Normally in a structured note, the dividend is incorporated into the pricing. With this deal, the dividend is locked out at 7%. They kept it fixed. It's a pretty innovative structure. The dividend is fixed at 0.3125 a quarter, so it is like a fixed to floating dividend swap - both parties protected - investor protected if dividends increase and bank protected if dividends decrease. I've never seen that before. I imagine this is beneficial for the investor as dividends would be expected to increase over time.

"My guts tell me someone asked for it. I don't see how a retail investor or high-net-worth client would be interested in this."

Larger on-demand offerings are not seen week after week, but they can help volume.

"These deals happen. It's just a reverse inquiry, no doubt about it," said Halpern.

The nature of the buyer may also have contributed to the large size of the offering, according to the structurer.

"This was the biggest deal last week, probably because an asset manager bought it," he said.

"While those deals are not the typical structured products, it's a good thing for the industry that we start seeing more and more of these. If the industry can deliver products not only to retail but also to asset management firms and institutional investors, it's obviously a plus. Potentially, it's a good way to generate more volume."

A pair with no cap

The second and third largest deals were a pair of offerings distributed by Morgan Stanley that combine the benefit of a digital payout with unlimited upside above that level along with a deep barrier on the downside. The trade-off is a relatively long tenor.

In the first of the pair, Barclays priced $38.5 million of trigger jump securities due May 21, 2019 linked to the Euro Stoxx 50 index. If the index gains at maturity, the payout will be par plus the greater of the index return and 40.5%. The downside barrier is 60% with full exposure to losses if the index falls by more than 40%. Morgan Stanley Wealth Management was the selected dealer.

In the second deal, Morgan Stanley priced $26.91 million of trigger jump securities due May 21, 2020 linked to the S&P 500 index. The structure is the same except for the digital payout, which is 35%.

"This pair of deals illustrates the no-cap trend," the structurer said.

"Issuers have to show investors that they can keep up with the market or even beat the market. We see products that do that, but they're just longer-dated like those two. That's where the action is going to be."

The top agent last week was Barclays with $150 million in six offerings, or 40% of the market. It was followed by JPMorgan and Morgan Stanley.

"We can pat ourselves on the shoulder, but much more needs to be done." - A structurer

"It's just a reverse inquiry, no doubt about it." - Joseph Halpern, chief executive officer of Exceed Investments, on the week's largest issue

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