As volume weakens and volatility remains high, buffers prevail in flight to safety

By Emma Trincal

New York, Oct. 19 - Action in the structured products market was tepid last week. Investors ignored leveraged notes with full risk exposure, a type of structure very much in vogue over the past months, and moved into buffered and partially protected products.

Issuance of non-exchange-traded notes declined by 14% in the week ended Friday to $423 million in 92 deals from $492 million in 110 deals the week before, according to data compiled by Prospect News. It was a four-day week due to the Columbus Day holiday on Monday.

Pause and rally

"It was a little slow, a consequence of the holidays and people staring at the headlines," a market participant said.

At the same time, the equity market rallied. The S&P 500 index rose 2.5% from Monday's close to Friday's, propelled by better-than-expected economic data in the United States and news from Europe that was perceived as more positive.

But the rally did not occur in a straight line. Volatility surged 14% for the week as measured by the CBOE Volatility index, or VIX.

On a month-to-month basis, sales declined to $914 million, down 7.15% from $985 million of issues priced in the same period of September.

For the year to date, though, volume is holding up. Issuance increased 13% to $34.73 billion from $30.7 billion for the same period of last year.

Buffers

The most distinctive trend last week was the rush to buffers and barriers in an attempt to reduce risk as volatility remained elevated.

While investors over the past few months have strongly bid on leveraged notes with full risk exposure, not one such deal priced last week, according to the most recent data compiled by Prospect News.

All leveraged deals offered either a 10% or 15% buffer or alternatively barriers in the 40% to 45% range.

Those leveraged products with partial downside protection grew 38.5% last week to $234 million, representing 55.5% of the total volume.

On a year-to-date basis, it's the opposite: Investors have bought fewer leveraged notes with partial protection ($5.34 billion, or 15.4% of the total volume) this year than they bought non-protected leveraged deals ($6.16 billion, or 17.75% of the volume).

"People are going back to buffers, definitely," the market participant said.

"There's a more conservative bent right now to sort of being more cautious. It's not surprising with the ups and downs of the market.

"We're experiencing a lot of volatility, and it's confusing. Volatility is within a range, but it's expanding. It's very difficult to position yourself."

Others say the trend is temporary as investors have yet to fully appreciate the severity of the risk they are taking, even with buffers.

"Some of the mood changes, and it appears to be a trend," a distributor said.

"But people need to understand that even buffered notes are risky. You're still putting your principal at risk."

Equity

The bid for equity was strong last week, up 39% at $365 million. The asset class representing a stunning 86% of the total, in contrast with its 68% market share for the year to date, according to data compiled by Prospect News.

Equity includes indexes, single stocks, stock baskets and equity exchange-traded funds.

Most of the push came from issues linked to single stocks, which saw their volume triple for the week to $56 million, while equity indexes grew in volume at a more moderate pace, up 31% at $309 million.

Equity indexes remained the dominant asset class, though, with 73% of the total, compared to stocks making for only 13% of the total.

"We're back in equity because people like the protection, they like the yield. It's the same story," the market participant said.

Difficult positioning

For this market participant, investors must have bought more equities last week either because the rally made them feel more confident or because they were expecting more price declines.

"A few weeks ago, the market was down 15% for the year. Then it started to rally. The euro strengthens, the dollar weakens, the market rallies. That's when people buy because they're dummies," he said.

But another factor was that prices remained attractively low despite last week's rebound.

"The stock market is down. It's a good time to get in, no question about it," he said.

"It's not easy. Everybody is trying to pick the bottom. You know the market is weak, but then, do you want to sit in cash?

"I think for people a little bit savvy, the reasoning was these are still good entry points, let's add a layer of protection and take advantage of the rally."

Reverse convertibles

Part of the revival of stocks last week was due to a pickup in reverse convertibles, which nearly tripled to $41 million.

Accounting for less than 10%, though, reverse convertibles' market share remains somewhat depressed compared to year-to-date figures, in which they represent more than 13% of the total.

On a month-to-month basis, this structure fell 21% to $57 million from $73 million.

"Reverse convertibles were in fashion when the market was up because you keep your principal and you collect a nice coupon," the distributor said.

"But in a volatile market, investors may wind up with a stock that's down. They get the harsh reality of it. Reverse convertible sales have been shrinking for a while now."

Commodities collapse

Issues linked to commodities last week were in free fall, down 88.5% to $21 million from $180 million the week before. They accounted for less than 5% of the sales, versus nearly 37% the week before. For the first half of the month, commodities jumped by 66% to $201 million and represented 22% of the total volume.

"People are getting a little bit concerned. Commodities have been volatile. And the economy sucks, nobody can really dispute that," the market participant said.

"The weaker economy, I think, more than the European crisis is what scares people."

Top deals

The top deal of the week, sold on Friday by JPMorgan as agent, was large in size and simple in structure.

HSBC USA Inc. priced $123.38 million of 0% buffered return enhanced notes due Oct. 31, 2012 linked to the S&P 500 index.

It offers two-times leverage on the upside and a 1.111% downside leverage factor past a 10% buffer. The upside is capped at 17.7%.

Deals last week decreased in size: Agents priced only three deals of more than $20 million versus eight the week before.

The second deal, smaller in size at $46.79 million although priced by the same agent on the same day, was issued by HSBC as well. It is exactly the same structure except for a slightly better cap at 18.9%.

Deal sizes fell after that. The third largest offering was brought to market by Morgan Stanley, which priced $20 million of contingent coupon range accrual notes due Oct. 19, 2017 linked to the S&P 500 index. The coupon is 8.25% per year multiplied by the proportion of days on which the index closes at or above 850. The notes offer full capital protection.

Finally, Goldman Sachs Group, Inc. sold the top commodities deal and fourth largest offering with an $18.25 million issue of 0% notes linked to gold. Investors will receive any increase in the price of gold up to 35.25% and benefit from an 80% barrier on the downside.

The top agent last week was JPMorgan, which priced eight deals totaling $175 million, or 41.43% of the total.

It was followed by Goldman Sachs with $108 million in 13 deals and UBS pricing 34 deals totaling $55 million.

"It was a little slow, a consequence of the holidays and people staring at the headlines." - A market participant

"... people need to understand that even buffered notes are risky." - A distributor

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