Structured products issuance $376 million for week; appetite for digitals, single indexes eyed

By Emma Trincal

New York, Oct. 26 – Agents priced $376 million of structured products in 71 deals in the week ended Friday, according to preliminary data compiled by Prospect News. The week was marked by the continued bid on digital products, which proportionally reduced the share of worst-of notes among index products to the benefit of single underliers.

It was another volatile week for the stock market, which closed on a positive note as a report in the Wall Street Journal suggested a lack of consensus among Federal Reserve members about how far the tightening policy should go, giving hopes to the market that the Fed may pivot. The absence of inflation data was also credited for the bounce.

The Nasdaq rose 5.2% for the week and the S&P 500 index jumped 4.7%.

Better days ahead

“The Federal Reserve has an extreme influence over the market,” said a market participant.

“I think going into year-end, we’re going to have a big rally. Everybody is overly pessimistic right now. Hedge funds are 100% net short. Their short positions are at all-time highs. CTAs are short too. All the trend followers are 100% net short,” he said.

Participants in structured notes are also very bearish and are buying puts at “record highs.”

Meanwhile, the economic picture is changing, he noted.

“Look at the U.K.’s intervention to defend the pound. In the U.S. you find hints that maybe the Fed’s tightening is overdone,” he said.

Another “hint” was the “collapse” in container shipping rates.

“They went through the roof last year, up 300%. This year, they’re down. Those rates are a pretty good indicator of inflation. We could see inflation being contained faster than most people think,” he said.

Insiders are buying equities, he added, which is another “hint,” and a notable reversal from last year when they were selling.

U-turn

“We could have a major turnaround, a major rally in the next three to five months.

“Hedge funds will be forced to chase the rally and so will the rest of the market, including retail. Everybody will be caught in the uptrend,” he said.

Whether such scenario would be another bear rally or a full-fledged market recovery, it will have direct implications for the industry, he said.

“For structured notes, it will kill the terms. Right now, with the high volatility, we’re having absolutely amazing terms. When volatility drops, income notes, yield notes will take a hit,” he said.

It’s unclear what investors’ response would be.

“Initially it will be a little bit of a shock. Terms may be terrible. But eventually, they’ll get used to it,” he said.

Autocalls, digitals

As always equity index underliers prevailed last week but with a new magnitude, capturing 90% of the volume, or $336 million in 39 deals. So far, single indexes have competed with worst-of indexes for the preferred payout type, but last week, the former clearly took over the later. Single index underliers accounted for 64% of the total issued while worst-of represented only 28% of it, according to the data.

Most single-index-linked notes are digital products, which have been making a wide stride over the recent months.

Last week for instance, 50% of sales went to autocallables while more than a third moved into digitals. Leverage was limited to less than 10% of total issuance.

There is a direct correlation between the growth of digitals and the retreat of worst-of payouts with index products, the market participant said. Most callable and autocallable income notes remain based on worst-of while digitals are single-asset based.

The dispersion risk introduced by the worst-of is more tolerable for clients in an income note, he explained, because such risk is nearly removed on the upside and minimized on the downside when markets decline.

“With income notes, the worst-of makes sense because the dispersion is on the upside, and since you don’t participate in it, you don’t lose any upside. You just have to be above barrier level and get your coupon,” he said.

“Your dispersion risk really is on the downside. But when a market is down, correlations go to one. That’s why most autocalls are done with worst-of, because the dispersion gives you a higher coupon. At the same time your dispersion risk is minimum.”

The same does not apply to digital notes.

“A lot of digitals we see are uncapped. So, it matters if the Russell is up 8% and the S&P, 12%. With digitals, the dispersion wouldn’t work,” he said.

Duration, funding rates

The main appeal of digital products for advisers and brokers is their “simplicity,” said a sellsider.

“Not having to explain the call features with a bullet note is a big plus,” he said.

From the issuer’s standpoint the bigger push toward digitals versus autocalls is by far the expected longer life of the bullet,” he added.

“With autocalls, although you don’t know the exact duration, the issuer is modeling out the expected life of the product, which is often shorter,” he said.

The highest probability of a call is usually on the first observation, he noted.

With autocalls on indexes, the uncertainty around the duration is relatively easy to hedge, he said.

“If you do a worst-of autocall on uncorrelated single stocks, I would say the hedge may be tricky. But not so much on indices.”

For traders, the real incentive to price digitals versus autocalls does not really lie in the hedging of the deal, he concluded.

“The real driving force behind digitals from an issuer’s standpoint is not risk management but the more attractive funding rate you get compared to autocalls,” he said.

On the other hand, autocallables remain highly valuable for issuers’ bottom line, he added.

“When the market is moving upwards, autocalls are attractive for brokers because the banks make more money in new issuance.

Single stocks, ETFs

Stocks and ETFs were underrepresented underlying asset classes last week, accounting for only 10% of the total. Figures remain preliminary and may change as more deals get filed with the Securities and Exchange Commission.

But the decline in stock-linked notes issuance is now a hallmark of this year’s bear market. Investors are bidding on broad-based indexes in the face of uncertainty. Since most ETFs are sector-based, ETFs and stock declines are attributable to the reluctance to make tactical bets on either sectors or companies, sources said.

A relatively uncommon single stock came out last week: Estee Lauder Cos. Inc., a French skincare manufacturer, which UBS AG, London Branch used for the pricing of a $1.5 million autocallable issue. Since 2011, this underlying stock has only been used in eight deals totaling $6 million, according to the data. The stock is down 45% for the year. Its implied volatility is 43.77%.

Worldwide opportunities

International equity bets on weighted baskets have resurfaced in the past couple of weeks.

The top deal last week, according to the preliminary data, was Toronto-Dominion Bank’s $29.14 million of 18-month digitals linked a basket consisting of the Euro Stoxx 50 index with a 36% weight, the Topix index with a 27% weight, the FTSE 100 index with a 19% weight, the Swiss Market index with a 10% weight and the S&P/ASX 200 index with an 8% weight. The uncapped digital note offers at maturity the greater of the basket return and 26.24%. Investors will be exposed to any basket decline.

During the previous week, Morgan Stanley Finance LLC priced two deals in excess of $32 million each on a similar basket (same components with slightly different weightings) with three-year and four-year tenors, respectively. Both products were in-the-money digitals with geared buffers.

The market participant said he understood the bid on international markets.

“Some people are tiptoeing back into the world. They’re picking up value and stepping back in,” he said.

For the sellsider, the size of those deals was a surprise.

“There’s a greater uncertainty in the international space. I guess if you don’t have conviction on the short to medium term growth, it may be an easy way to maintain international exposure in your portfolio,” he said.

“But I can’t make great sense of moving assets to international equity right now in this highly uncertain and volatile environment.”

Issuance volume

The tally for the year through Oct. 21 is down 12.7% to $68.83 billion from $78.83 billion.

The number of offerings during the period fell by more than a third to 15,491 from 23,789.

September was not a good month for equities, but the return of Barclays in the issuance market along with the billions in proceeds it released to investors through its rescission offer, boosted volume for this month, as several sources predicted.

The tally for September was $8.04 billion, placing the month in third position after March and January.

Citigroup Global Markets Holdings Inc. was the top issuer last month with $1.13 billion. Barclays Bank plc came in fourth place with $790 million.

Last week’s top agent was UBS with 30 deals totaling $118 million, or 31.5% of the total. It was followed by Citigroup and TD Securities (USA) LLC.

The No. 1 issuer was Citigroup Global Markets Holdings with $88 million in 10 deals, a 23.5% share.

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