Structured products issuance volume strong for month, year; expectations of higher coupons eyed

By Emma Trincal

New York, Aug. 23 – Last week’s market was all about interest rates making multi-year highs, placing bonds in direct competition with structured notes, a sellsider said.

Yet the trend seems to hurt the stock market more than it impedes issuance of structured notes so far this month.

Sales of structured notes remained robust despite a 10-year Treasury yield hitting a six-year high last week at 4.35%.

This month’s tally of structured products issuance through Aug. 18 amounted to $2.97 billion, a 16% increase from July’s $2.56 billion during the same time and a 3.5% rise from a year ago, according to preliminary data compiled by Prospect News.

“There’s been renewed call activity recently,” a market participant said.

For the year, volume has now caught up with last year and remains flat, which represents progress, compared to a decline earlier this year.

Hawkish Fed

Last week’s Federal Reserve’s minutes indicated that the Federal Open Market Committee may still continue to hike rates, which led yields to tick higher, putting both the stock and the bond markets under pressure.

The Russell 2000 index lost 3.4% and the Nasdaq fell 2.6%, closing the worst week since March.

For structured notes marketers, higher risk-free rates are a new objection to deal with when pitching the products to investors.

Double-digit

“Rising rates create a higher ballgame to meet clients’ expectations,” a sellsider said.

“In the past, 7% or 8% coupons were attractive. Now rates on T-bills offer more than 5%. If you’re going to take equity risk, you’re looking for double that amount. That’s when investors begin to pay attention.”

If higher-yielding money markets and Treasuries have not hurt issuance of structured notes yet, it now takes some effort on the part of issuers to keep up, he said.

Changing environment

“Rising rates don’t necessarily make it more difficult to sell structured notes. It’s just a different environment. It has an impact on what people are looking for,” he said.

“Higher rates help pricing because you have more money to spend on the underlying options. But volatility remains low although it did pick up somehow this month.”

Once volatility really rises, some advisers will enter the market in search of better economics, he predicted.

Yield boosters

In the meantime, issuers have found creative solutions to price the coupons advisers are looking for.

Using worst-of is no longer enough, he said.

“You have to do more. Now you can make the note issuer callable instead of autocallable. You get more yield that way.

“You can also use a daily observation feature on the coupon or even on the principal. That allows you to increase the downside protection while still getting a higher coupon.

Another approach has been to shorten the no-call period, for instance from a year to a quarter or to eliminate it altogether, he added.

“You can also replace one or two of the safest U.S. indices with the Nasdaq or with one of the European indices. You still have broad-based indices but more volatility and less correlation, which can also boost the return,” he said.

Another solution consisted of “playing” with different maturities.

“Volatility may be more favorable on one maturity versus another.”

It’s impossible to tell if this factor plays to the advantage of shorter versus longer tenors because it depends on several factors, such as the underliers and the structure, he noted. But the method seems to work.

“If a client does a lot of autocalls, from their perspective, there is not a huge difference in expected durations,” he said.

On the short end

Some recent deals this month offered surprisingly large buffers over very short tenors, according to data compiled by Prospect News.

For instance, UBS AG, London Branch priced last week $12.5 million of 13-month leveraged notes on the S&P 500 index giving investors 1.25x the index gain capped at 13.35% with a 25% geared buffer on the downside.

Another example was JPMorgan Chase Financial Co. LLC’s $1 million of two-year uncapped leveraged notes tied to the worst of the Nasdaq-100 index, the Russell 2000 index and the S&P 500 index. The upside leverage multiple was about 1.1 and investors had a 20% regular buffer with absolute return.

“I think it’s rate-driven. You get higher yields on the short end of the curve,” said the market participant.

The record inversion of the Treasury yield curve indeed is showing higher rates for T-bills than Treasury notes. The four-month Treasury currently yields 5.499% and the one-year, 5.362% while longer maturities yield below 5%.

Digital push

Digital notes are on the rise, accounting for nearly 20% of this month’s notional in 44 deals totaling $551 million.

Five of those deals had a size in excess of $35 million. GS Finance Corp. issued the largest one for $97 million based on the S&P 500 index.

“It’s one of the simplest structures to understand and to explain and that’s what makes digitals pretty compelling. You don’t have all the moving parts of an autocall. It’s transparent,” said the sellsider.

The majority of those digital trades are structured on single equity indexes. Occasionally though, some issuers have used digitals to price deals on oil.

The largest one this month was Citigroup Global Markets Holdings Inc.’s $25.98 million of 13-month notes linked to the Stoxx Europe 600 Oil & Gas index, a not-so common underlier.

The 90% digital strike allowed for the payment of a 13.5% return. The downside offered a 10% geared buffer.

Oil prices are beginning to cool off this month after rallying in June and July.

Callable, leveraged

Callable notes made for 58% of this month’s total versus 64% last month. The top deal so far was Citigroup’s $99.78 million issue of one-year callable notes tied to the worst of the Nasdaq-100 index, Russell 2000 index and S&P 500. The note paid a fixed rate of 9.52% per annum, showing a six-month no call and a 70% barrier at maturity.

Leverage accounted for 16% of this month’s notional. Bank of Nova Scotia’s $73.56 million issue was the top one in this category. The 1.75-year deal referenced an unequally weighted basket of international indexes, paying 3x the gain up to a 39.6% cap with no downside protection.

Average size

After being negative, the tally for the year to date is now virtually flat at $57.57 billion from $57.58 billion a year ago.

One notable trend this year has been the steep decline in the deal count with an unexpected effect: sales have held up and the average deal size has increased.

Issuers priced 13,397 deals this year versus 17,819 a year ago, a 25% decline. Meanwhile the average offering size jumped to $4.15 million from $3.23 million.

The market participant said that the shrinking deal count could be due to the way notional sales get reinvested.

“There’s a high correlation in volume between what’s being called and what gets rolled into new autocalls. If I get $150 million called this month, I’m pretty certain that I’m going to reinvest just about $150 million. But I may not roll this amount into the same number of deals,” he said.

“If I have three deals being called this month, I may put one replacement out there in one deal. If 50 deals get called, I may only need 10 to recapture that notional.

The explanation was “anecdotal” however, he noted.

“I can’t say for sure if what we see at our firm reflects a broader market trend.

“You could also have a couple of big deals that really skew the average size,” he said.

To be sure, the number of issues in excess of $50 million this year was 92 versus 75 a year ago, according to the data.

Last week’s volume was $254 million in 72 deals, according to preliminary data compiled by Prospect News. These figures will likely be revised upward.

UBS was the top agent for the week, pricing 25.5% of the market in 42 deals totaling $65 million. Bank of Nova Scotia was the No. 1 issuer with $51 million in five deals, a 20.1% share.

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