Investors chasing the rally or fearing a sell-off shy away from notes or seek more protection

By Emma Trincal

New York, March 14 - Lackluster volume, reduced deal sizes and a drop in issues linked to single stocks confirm that investors continue to stay on the sidelines as the future direction of the market remains uncertain, sources said.

Volume down

Volume for the month through Friday fell by 19% to $634 million from $785 million during the same period of February.

For the year to date, the volume has declined by 35% to $6.62 billion so far this year from $10.19 billion in the first 69 days of 2011.

The decline in the number of larger deals was also seen as a sign of weakness.

Firms priced 13 deals of $50 million or more this year versus 45 in the same period of last year, according to Prospect News data.

Simultaneously, the U.S. equity market has rallied strongly since December, with the S&P 500 index up nearly 11%.

On Wednesday, the benchmark hit the 1,400 threshold, its highest intraday level since June 2008.

Sources said the rally is giving structured notes investors pause.

"Volume is down because the market has run up so much. The probability of the market being down 13 to 24 months from now is higher than it was three months ago," said Andrew Valentine Pool, main trader at Regatta Research & Money Management.

Stocks not in favor

Stocks, more volatile than indexes or baskets of indexes, have particularly suffered from the mixed sentiment investors have expressed about the rally, a sellsider said.

Single-stock issuance dropped by 70% to $55 million so far in March from $184 million during the same period of February. This asset class fell to 8.75% of the market this month from 23.5% last month.

UBS dominates the asset class but with very small deals.

Last week, the firm sold nearly 80% of the 69 stock-linked products brought to market. An industry source said that UBS has developed a platform allowing financial advisers to sell structured notes linked to stocks at very low minimum sizes.

On average, UBS' trigger autocallables or trigger phoenix autocallables had a $355,000 size last week, according to Prospect News data.

"[Issues linked to] stocks have plummeted for two reasons," the sellsider said.

"For one, stocks have gone up a lot, so people don't want to take the downside risk. That's one school of thought.

"And then you have those who think that the rally is far from over, and they don't want to limit their upside.

"You no longer have that view that things are going to trade range bound. If you believe in either a rally or a sell-off, stock deals in particular start to drop off."

For some, single stocks carry too much headline risk.

"A lot of those stocks have broken resistance," the sellsider said.

"All you need is one of the CEOs of a well-known company getting his hands caught in the cookie jar."

Sometimes investors want to be bullish but lack the conviction, a market participant said.

"There's a mixed feeling. A lot of people seem cautious. Yes the market has been up, but when you talk to clients, people are very bearish," he said.

"Does it really feel like the S&P 500 is at 1,400? Last time the S&P 500 was at 1,400, people were a little bit more upbeat.

"If you look at the news, the U.S. unemployment is still high, Europe is still a mess. It doesn't feel like you should be having a rally."

Protection wanted

Investors in structured notes are increasingly buying protection, often in the form of downside barriers or buffers, the data shows.

Last week for instance, leveraged notes with partial downside protection accounted for 22.6% of the volume against 16.5% the week before.

Pure leveraged deals without any protection represented only 0.3% of the total versus 4.75% the week before.

One factor playing in favor of investors' bid for increased protection was the recent Treasury sell-off induced by improved economic data, the sellsider said.

"Recently rates have gone up. The five-year swaps since the start of the month are higher than at the beginning of the month," this sellsider said, adding that the trend has allowed issuers to price better terms especially on longer-dated fully principal-protected products.

Another way to add protection was to incorporate downside leverage. Agents did just that last week as evidenced by the data. All of the top 10 buffered notes featured downside leverage factors varying from 1.1111 for most of the products to 1.25 or 1.1765 with several products sold by Goldman Sachs.

"People do that to offer bigger buffers," the sellsider said.

"With the downside gearing you can either increase the buffer or offer a higher coupon or a higher participation.

"Clearly people want the downside protection. The market went up so much, there is just a lot of demand for that."

Buffered notes top

Buffered notes prevailed last week in the list of big deals.

Nine out of the top 10 deals had buffers ranging from 10% to 22.2% for a 1.25-year average tenor, according to the data.

Barclays Bank plc priced the No. 1 deal with $32 million of 0% buffered return enhanced notes due March 27, 2013 linked to the S&P 500 index.

The upside leverage is two times, the upside cap is 12.4%, and the buffer is 10% with a 1.1111 leveraged downside beyond the buffer. JPMorgan was the agent.

Another big leveraged buffered note - and the third largest offering of the week - was brought to market by JPMorgan Chase & Co. with its $26.6 million of 0% notes due March 27, 2013 linked to a weighted basket of three buffered return enhanced components. The basket included the Euro Stoxx 50 index with a 55% weight, the Topix index with a 23% weight and the FTSE 100 index with a 22% weight.

The two-times leverage, the 19.2% cap and the 10% buffer are applied separately to each basket component. Again the downside beyond the buffer is leveraged at a rate of 1.1111 per point of decline.

The second largest deal offered 20% downside protection in a barrier format on an 18-month tenor.

HSBC USA Inc. priced $28.84 million of 0% knock-out buffer notes due Sept. 13, 2013 linked to a basket of currencies. The equally weighted basket includes the Brazilian real, the Mexican peso and the Canadian dollar. The basket's level will increase if it appreciates relative to the U.S. dollar.

In the absence of a knock-out, the payout at maturity will be par plus the greater of the basket return and 12.3%.

JPMorgan was the agent.

"We like buffers, and for a 13-month to 24-month enhanced growth note, we'd like to have at least 20%," said Pool. "We would prefer to have 25%, but there are not that many.

"When we're not that impressed with the downside protection, we purchase the ETF to at least get some run up and get out whenever we need."

Sources suggested that other bullish participants may also be substituting ETFs for structured notes when the price to pay for the downside protection appears to limit the upside too much.

Dual directional, world exposure

Dual directional notes continue to be popular as they satisfy the need to make a profit regardless of the direction of the market, said Pool, who is pricing one for his firm with an issuer.

"We like those twin win [notes] because if the market is down in a range, you make money. If it's up in a range, you make money. We think that it meets investors' demand, and that's why those products are being issued," he said.

HSBC USA priced $23.2 million of 0% dual index notes due Dec. 13, 2012 linked to the S&P 500 index and the MSCI All Country Asia ex Japan index. It was the fourth largest deal last week.

Several of the top deals gave investors exposure to global markets either via an index or currencies. It was the case for instance with the HSBC notes tied to the Brazilian real, Mexican peso and Canadian dollar. Several large deals also gave global exposure through equity indexes, such as JPMorgan's $26.6 million deal on the Euro Stoxx 50, Topix and FTSE 100 indexes, the HSBC dual index notes on the MSCI All Country Asia ex Japan index and Royal Bank of Canada's $17.3 million offering of notes linked to the MSCI All Country World index.

"I'm surprised so many of those deals were global. We like Asia, but we stay away from Europe because while we know it's going to be fixed, we're just not sure of the timing," Pool said.

HSBC was the top agent last week with $69 million sold in eight deals for 21% of the total. It was followed by JPMorgan and Barclays.

Figures in this article do not take into account exchange-traded notes or certificates of deposit.

"The probability of the market being down 13 to 24 months from now is higher than it was three months ago." - Andrew Valentine Pool, main trader at Regatta Research & Money Management

"Clearly people want the downside protection. The market went up so much, there is just a lot of demand for that." - A sellsider

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