Outlook 2010: Structured products market rebounds after economic shock, Lehman Brothers demise

By Emma Trincal

New York, Dec. 31 - The year 2009 will be remembered as a year of market recovery after the shock induced by the fall of Lehman Brothers Holdings Inc. and the credit crisis. While all markets remained shattered in the early part of 2009, a rebound began in the early summer in the United States.

"It was a surprisingly strong second half of the year, driven by investors who may have missed out on the early part of the recovery of indexes, and jumped in during the third and fourth quarters," said Keith Styrcula, chairman of the Structured Products Association.

"Also, market-linked CDs were a popular, government-backed alternative for investors, and we saw record volumes.

"The second half was also marked by large deals measured in hundreds of millions in size, and unprecedented. It suggests that structured products have risen above the credit concerns and bodes well for the momentum heading into 2010."

The year began with many challenges, among which, investors' reluctance to be exposed to the creditworthiness of a financial institution after an unprecedented banking crisis.

Investors in the early part of the year were simply reluctant to take any kind of risk. In addition, the number of issuers shrank considerably after a wave of bank acquisitions and consolidation that took place during or shortly after the U.S. credit crunch when the banking system nearly collapsed. The result was more concentration with a fewer number of players.

"One of the big themes for the year was the streamlined structured products industry, with bank mergers induced by the bailout and the departure of several European competitors," said Styrcula.

But the path to recovery ended up being much smoother than many would have expected, which is perhaps one of the greatest surprises of the year.

As of Dec. 21, total U.S. structured products issuance for 2009 was $36.192 billion in 4,109 deals, which is about 60% of the volume recorded the year before when issuers priced $60.486 billion in 6,446 deals, according to data compiled by Prospect News. These numbers include all U.S. registered notes and some certificate of deposit offerings, which individual banks have reported to Prospect News.

The shrinking size of the pool of issuers has not turned for the worse, sources said. In fact, it may have boosted competition among the firms.

"Since Lehman, we've seen several issuers disappear from the marketplace," a sellsider said, adding that as a result, consolidation brought some of the most resilient names to the forefront.

"Clearly, Barclays, UBS, JPMorgan and Goldman Sachs are the 'survivors,' and will garner much of the structured note business going forward," this sellsider said.

Protection wanted

One of the factors that helped issuers weather the credit crisis storm of last winter was the robust pace of CDs.

Even if riskier structures made a comeback in the second half of the year, investors' appetite for Federal Deposit Insurance Corp.-insured products is a trend that has caught the attention of many, especially among banks.

"The most popular structure [in 2009] was the fully protected FDIC-insured market linked," said the sellsider.

"Investors at the beginning of the year were scared to death about credit risk. CDs were the perfect product at the time because they were FDIC-insured. It was a great way to get in the market. CDs will remain popular in 2010 but will not be as important as in 2009," this sellsider added.

"The prominent trend of the first part of 2009, which began toward the back end of 2008, was the robust volume of FDIC-CDs as a result of the credit crisis. CD issuance in the early part of 2009 became prominent, especially if you compare it to the same period in 2008 or 2007," said Richard Couzens, head of U.S. products origination, Investor Solutions at Barclays Capital.

"In the first half of 2007, for instance, CDs in volume represented only 8% to 10% of the total U.S. structured product market. Fast forward to 2009, this percentage increased to 20% to 25%, according to estimates," Couzens said.

Back to risk

"As we approached the middle part of the year, the CD issuance trend continued to be consistently strong with monthly issuance volumes stabilizing," said Couzens. "We started to see investors re-entering the market, capturing opportunities with the market rally that began in March. This was also at the time when investors' risk appetite shifted accordingly."

For the equity market, the turning point was the beginning of the rally in March. It had a positive impact on structured products supply and demand.

"The switch coincided with the positive return in the equity markets. Much picked up when the market continued to do well," said the sellsider.

"Cautious optimism was the common sentiment leading to a renewed appetite for risk," said Couzens.

"This in turn led to the second big trend seen for the year, which began in the summer - the reemergence of some of the more traditional structures, such as reverse convertibles, in part related to the equity market recovery and investors' demand for yield enhancement. Others include enhanced return notes following a recovery theme and more recently healthy autocallable volume and absolute return plays," Couzens said.

Reverse convertible products are short-term notes often tied to the price of a single stock that gives investors the option to collect a very high coupon.

Autocallable structures are notes with a contingent minimum coupon, which can get called back by the issuer if the underlying asset hits a certain threshold during the observation period.

Both types of products have been very popular due to their high coupon payouts.

"The return of income-oriented structured products was one of the big trends of the year," said Styrcula.

"I think autocallables were one of the big developments of 2009 and I am sure it will continue full speed in 2010," the sellsider said.

Randy Pegg, head of structured products at Advisors Asset Management, a distributor, predicted a continuation of the "risk trade" for the year ahead with "more reverse convertibles and buffered notes."

Credit concerns

"Bank balance sheets are getting stronger every day, and investors are comfortable with credit risk again. 2010 could be a record year for structured products," said the sellsider. "The good news is that there's a lot of better credit out there among banks," although "some names are still suffering."

Serge Troyanovksy, head of retail distribution North America at BNP Paribas, said that credit concerns were manifest during the early part of the year.

"We have seen a significantly increased focus on the credit quality of the issuers in the beginning of 2009. Indeed many investors would avoid products issued by the lower rated issuers. Investors wanted 100% principal protection from an AA-rated issuer or an investment in a CD insured by the FDIC," said Troyanovksy. "However, as the credit markets stabilized and the equity markets showed significant appreciation during 2009, investors are once again focusing on the more opportunistic products."

If most experts agreed that investors have regained some level of confidence, they remain unsure about how resilient investors would continue to be in the coming year.

For some, credit concerns have not entirely receded after the severe banking crisis of 2008-09 and investors are likely to remain cautious, if not skittish in 2010.

"Principal protected products will remain the preferred structure with about 60% to 70% of total issuance," said Pegg.

"People are still hesitant to take the credit risk, especially with regards to the negative headlines around Lehman Brothers. Issuance will not reach the level it had in 2007-08. But it will be better in 2010 than this year," Pegg predicted.

Others believe that government actions took a significant part in reducing credit fears. They think that investors' comfort level with credit risk will ultimately depend on the extension of monetary or fiscal policies designed to restore confidence in the credit markets.

"Credit concerns have eased with the Fed [Federal Reserve Board] guarantees for certain bank debts," said Jeremy Berman, managing partner at Wavecrest Asset Management in New York. "But if the Fed guarantees go away, corporate spreads will widen. It has already happened, with bank spreads widening more for certain institutions than others."

Berman said that this level of uncertainty defines how his firm protects its investors.

"The way we manage risk consists of separating credit risk from risk return payoff. In one pocket of risk we hedge our credit exposure. In another, we address the payout. We think it's safer to hedge credit risk and market risk separately."

Some believe that credit risk is never something investors should second guess, regardless of market conditions. "Credit risk concerns have eased since early 2009," said Couzens. But credit risk should always be a "key consideration" for structured products investors when making an investment decision, he said.

Big is back

The combination of several trends - a big commodity boom, low interest rates fueling demand for yield and innovative distribution channels contributed to the return of the big deals. The manifestation of that trend was a number of exceptionally large and innovative exchange-traded notes coming to market.

While the number of large deals in 2009 remains much smaller than in the year before, issuance of deals in excess of $100 million suddenly built up in momentum in the last 45 days of 2009 when almost all of those transactions priced at a strong pace.

Some factors behind the larger size of some year-end deals were related to distribution and marketing.

"The partnership of investment banks with commercial banks to offer a diversified pool of market-linked CDs was an important trend," said the sellsider. He mentioned the case of Deutsche Bank partnering with Wells Fargo as well as UBS working with SunTrust on joint distribution of CDs.

When dealers agree to mutually distribute the deals they issue - something market participants often call "open architecture" - the result is higher volumes of distribution, he said.

"More firms will move toward real open architecture. Brokers won't accept uncompetitive pricing and will ask that their firm distribute other firms' products. Without open architecture, your deals are not competitive," the sellsider added.

Another factor behind the increasing volume was the low interest rate environment. The search for yield boosted issuance while being at the same time one of the drivers behind a strong commodity boom.

Exchange-traded note issues accounted for the rise of larger deals this year. In general, ETNs, which can be bought and sold on an exchange at any time, sell in larger blocks than traditional structured products because of their liquidity.

In addition, the year saw the launch of a few innovative ETNs, which were well received by the market.

One was the Barclays' iPath VIX ETN linked to VIX, the CBOE volatility index.

"Looking at volatility as an asset class was a highlight market theme in 2008 and 2009," said Couzens. "Since we launched the VIX ETNs in February, the product has continued to see healthy interest and demand, displaying a solid trading volume."

Couzens said that ETNs are good vehicles to give investors access to difficult-to-reach markets or asset classes, adding that volatility and commodity ETNs are good examples of this strategy.

Given the appeal of ETNs for investors looking for access and liquidity, several market participants are bullish on those investments for 2010 and further.

"ETNs are only at the very beginning of their lifecycle. The ETN market will be north of $100 billion by the end of the decade," predicted the sellsider.

Another popular deal was the series of long and short leveraged ETNs linked to the S&P 500 Total Return index the bank priced in November. "It was another innovative solution. It's too soon to measure its success yet as it is a brand new product. But you definitely have the characteristics of an innovative structure," said Couzens.

The end of complexity

More than size, simplicity was one of the trademarks of 2009. Sources said that innovation and complexity receded in 2009, as investors' demand focused on simpler deals, not complex structures.

"You did not see a lot of innovation in payoff or underlyings this year. There was a time when complex was good. But when CDOs [collateralized debt obligations] blew up, people realized that complexity didn't really add value. The U.S. market in general has been much less focused on payoff innovation, and that will continue to be the case in the coming year, in fact now even more than before. People just want deals that are easy to understand," said the sellsider.

Several sources said that investors no longer show interest in notes linked to complex indexes. Instead, they prefer well-known, highly liquid benchmarks such as the S&P 500, the Dow Jones Industrial Average or the Nasdaq.

"It's one of the trends of the year. People don't want proprietary indexes. They look for broad, well-known indexes, not esoteric ones," said the sellsider. "They don't want something that can only be hedged by one firm."

"Simplicity was a continued trend highlighted in 2009, and it will continue to be so in the year 2010," Barclays' Couzens said. "The products that get the most traction are often the most simple. That is one of the reasons behind the success of exchange-traded notes. Those products offer simplicity and liquidity, two traits that investors value a lot."

Wavecrest Asset Management does not purchase a lot of the off-the-shelf structures, Berman said.

However, he was in a position to note how much "simplicity made a strong comeback" this year.

"One of the effects of the credit crisis of last year, early 2009, was that structured investments got a lot simpler," he said.

"In the structured products world, the quant guys come up with better mouse traps," said Pegg. "We have had more success with plain vanilla deals. We had difficulty distributing proprietary indexes because retail customers don't understand it."

Pegg noted that banks' proprietary models invented to facilitate access to the commodity market were not necessarily a hit among his clients. "We found that investors prefer the benchmark indexes such as the Rogers commodity index, the AIG index or the Goldman Sachs commodity index," he said.

The same applied to equities, he noted.

"Investors want big things that they know, such as the S&P 500 index or the Dow Jones Industrial versus algorithmic-based indexes. Overall, we've seen a trend toward more plain-vanilla structures versus the complex alpha-based products," he said.

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