Monthly volume falls 25% amid fiscal fears, growing uncertainty; investors focus on digitals

By Emma Trincal

New York, Nov. 21 - The market showed slow volume in the holiday-shortened week ended Friday with investors biding on digital notes as bipartisan tensions continued to feed worries about the looming fiscal cliff along with other concerns coming from global headwinds. The S&P 500 ended 2.2% lower after disappointing economic data and renewed concerns about Europe.

For the month up to Nov. 17, volume has declined by 25% compared to October with $676 million in November compared to $906 million during the same time last month.

Agents sold $242 million last week, down 29% from the $341 million volume priced the week before, according to data compiled by Prospect News. The number of deals remained relatively stable at 119 versus 123 the week before. The largest deal was only $36 million in size. Six offerings exceeded $10 million, the data showed.

Even compared to October's second week of business, last week showed a 31% decline in volume from $341 million in the week ended Oct. 12.

Fear of the unknown

Sources attributed the slowdown to the climate of uncertainty that makes investors hesitant to put money to work.

"People don't have any real conviction or view," the market participant said.

"No one really has any clue about what's going to happen, and that's probably the main reason why things are so slow on top of many other factors," a sellsider said.

"Now that we have a president, people hear about the fiscal cliff, they don't hear good news from Europe... Look at France that's just been downgraded. They're starting to wonder if the economy is going to improve at all," he added.

Sebastien Galy, senior currency strategist at Societe Generale, compiled the risk scenarios various strategists have in mind, summarizing the main ones as: rates rising; hard landing in China; war in the Middle East; "the old bogey man Europe falling apart"; and of course the impending fiscal gridlock in Washington.

"There are lot of factors involved in the weak issuance we're seeing this year," said the sellsider.

"It's a combination of low interest rates, low volatility and the continued uncertainty, the lack of visibility.

"If we have a fiscal cliff, we'll have higher taxes, particularly on dividends and capital gains. Obviously, this is on people's minds. It will affect every investor. It's not exactly a great incentive to put new money in the market."

Negative headlines and a divided Congress may very well drag the country into recession, he said.

"We had the same issue last year around the debt ceiling debate, which led to a sell-off. The government at the time decided to kick the can down the road. They might very well do it again. And for the investor, the reasoning is if they don't have a long-term view on the economy, why should I? A lot of the uncertainty comes from the government," he said.

Digital solution

Investors last week expressed an increased interest in digital notes, which accounted for three out of the top four offerings, including the top one. Sources attributed this development to the same pattern that contributes to make investors skittish about putting money to work - a lack of conviction and a reduced bullishness ahead of uncertain events.

"The trend for the whole year is that we are averaging down 20% versus last year," the sellsider said.

"Issuers are doing more deals but smaller deals."

Volume is down 18% so far this year to $31.19 billion as of Nov. 17 from $37.99 billion during the same period last year, according to the data.

Meanwhile, the number of deals has increased by 16% this year to 7,090 from 6,100.

"You see more digital payouts because people don't have a strong view that the market is going to appreciate over next year. Having your return enhanced to a point that you know in advance makes more sense than a leveraged buffered note," the sellsider said.

"The digitals are replacing the typical leveraged structures that we used to see in the market last year or earlier this year."

That is not to say that leverage is not the most popular structure, he noted. But investors are looking for alternatives when they lack optimism.

"Leverage buffered notes are harder to price. The buffers have become very expensive so you end up with a very low cap. This makes it much harder to sell. Deciding what the best cap should be is a pricing challenge for many structurers," he said.

Leveraged return notes with partial downside protection have increased by less than 2% this year from last year to $6.47 billion from $6.35 billion, according to the data.

"I would imagine that most of those deals priced earlier this year," the sellsider said.

"Ultimately whatever gets priced is a result of what the client's view is.

"If they feel pessimistic about what's going to happen, leverage doesn't make a lot of sense. Leverage is a good story when the view is positive; otherwise, it's not going to work. If you have two-times leverage and the underlying is up only 1%, you get 2% and so what? It makes more sense to have a digital payout," he said.

The market participant agreed.

"The structure you pick depends on what your view is," he said.

"Leverage is not going to give you much in a range bound market. You have to be bullish to use leverage."

"In a single-digit market, a digital can give you double-digit returns...people are comfortable with that," he added.

"Some digital structures give you an extra upside. Most have a participation above the digital as well," he said.

Top offerings

A few offerings among last week's top deals exemplified the types of digital structures that give investors enhanced returns as an alternative to leverage.

One for example was the No. 1 deal: Royal Bank of Canada's $36.03 million of 7.5% STEP Income Securities due Nov. 27, 2013 linked to JPMorgan Chase & Co. shares distributed by Bank of America Merrill Lynch.

In addition to the fixed-interest payable monthly, investors would get par plus an 8.37% step payment if JPMorgan shares finished at or above the step level of 107.5% of the initial price.

If the stock finished at or above the initial share price but below the step level, the payout would be par.

Investors would be exposed to losses if the final share price was less than the initial price.

"For the issuer, it makes more sense to have a digital payout instead of figuring out what the cap should be," the sellsider said.

"The desk has an easier time hedging the risk because they know that their liability is going to be the digital, as opposed to constantly monitoring if the index is up to find out what they're liability is going to be.

"And from the investors' standpoint, it's always appealing to know what the outcome is going to be."

The other digital product was issued by Bank of America Corp. with its $11.81 million of autocallable market-linked step-up notes due Nov. 30, 2015 linked to the S&P 500 index. It was the third offering in size. Investors received full upside participation with no cap if the index finished at or above the step-up value - 145.3% of the initial level. If the index return was positive but lower than the step-up value, they would get the digital payout 45.3%. The deal included a 95% barrier on the downside.

The notes were automatically called if the index closed at or above the initial level on either call observation date, with an 8.5% premium per year.

Finally, HSBC USA Inc. priced the fourth largest deal in its $10.78 million of 0% barrier notes due Dec. 3, 2013 with step-up digital return linked to the Mexican peso relative to the dollar. The structure offered different types of digital payouts based on the underlying performance of the currency at maturity. Those were 23.45% if the returns exceeded 5%; 5% for a positive return below 5%; and par if the currency return finished negative but above an 85% barrier, otherwise, full exposure to the losses. The underwriter was J.P. Morgan Securities LLC as the agent.

Seven leveraged notes with partial protection priced last week. The largest one - also the No. 2 deal overall - came from Royal Bank of Canada with a $12.95 million of 0% buffered enhanced return notes due Nov. 19, 2014 linked to the S&P 500 index.

The payout at maturity was par plus 1.5 times any gain in the index, up to a maximum return of 16.725%.

Investors would receive par if the index fell by up to 15% and would lose 1.1765% for each 1% decline beyond 15%.

The top agent last week was Bank of America with $47.84 million in two deals.

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