Short week shows tepid volume; investor bid on autocallable notes seen as growing trend

By Emma Trincal

New York, Nov. 28 - Thanksgiving week dampened sales of structured products, with volume down 50% from the prior week, according to data compiled by Prospect News, but sources said that issuance has been weak for some time now and the entire year disappointing.

A top trend seen last week was investors' appetite for reverse convertible notes with an autocallable feature. This structured type is also the fastest growing on a year-to-date basis, according to the data.

Volume is down by various standards, according to the data.

Agents last week sold $199 million in 71 deals versus $394 million in 130 deals the week before.

For November to the 24th, sales amounted to $1.03 billion, down 53% from the same period last year, which saw the pricing of $2.18 billion, according to the data.

Sales this month have declined by 24% from $1.35 billion in the comparable period in October.

"We still haven't finished the month. Some deals are being priced today, and tomorrow," a market participant said.

And the Thanksgiving halt certainly did not help, sources said. However, a comparison with the same holiday week last year showed that things have gotten even worse: $1.01 billion were priced between Nov. 21 and Nov. 25 of 2011 - last year's Thanksgiving week - which points to an 80% decline this year.

Slump

"The market is awful to create structured products," the market participant said.

"We have extremely low rates, extremely tight credit spreads.

"It's a moody market. The fiscal cliff is scaring a lot of people.

"Most people are naturally bullish. It's psychologically difficult to put on a bearish trade. Clients are likely to do nothing rather than placing bearish bets."

Perhaps the most concerning figure is on a year-over-year basis, sources said, as the slump sees no signs of improvement.

Agents sold $31.54 billion year to date, down 19.71% from the $39.29 billion volume priced during this same time last year.

"The year-to-date figure is what matters, really," a structurer said. "The fact that we are down 20% from last year is not good news. Let's hope the trend is not going to continue and that things will stabilize for a better 2013."

Another sign of year-do-date weakness is the number of deals in excess of $50 million in size, which has nearly fallen by half to 61 this year from 112 in 2011.

"Volume is really a function of the market," said Thomas Livingston, Halliday Financial Group's director of structured products.

"Banks don't really need capital. Their funding rates are very low. Volatility is not that high either. It's hard to squeeze any kind of return when you don't have enough volatility in the market. We're definitely not seeing the structures we looked at a year ago," he added.

"Volatility is your friend when you try to put these structures out.

"I suspect that this will change. Most of the time there is a part of a portfolio that can use structured products. But for now it's very difficult to put deals that offer a good risk return to the client unless you go out a lot longer. And people don't like to do that," he said.

Autocall appeal

One visible trend seen last week but also on a year-to-date basis is the solid bid on reverse convertible notes with an autocall feature.

Those deals are often structured around a final barrier at a lower strike than the initial price, which gives investors - if not breached - protection while putting them at risk of losing their entire principal if the threshold does get hit. Separately, a contingent coupon is paid on a periodic observation date - usually quarterly - if the underlying closes above the barrier. A higher barrier, typically at par, will determine whether the notes are automatically called, which is established on the observation date.

Most of those deals are small in size. Twenty-five offerings of that type were issued last week totaling $38 million, or 19% of the total. It was the most important structure category after leverage, according to the data and one that grew the most from the week before at a 62% pace.

On a year-to-date basis, these types of products remained limited in volume, accounting for only 10.80% of the total with $3.40 billion. But it was the fastest-growing structure, up 97% from the prior year.

Sources said that the likelihood of the call, which shortens the maturity, is what makes those products popular because investors do not want to be locked in for too long. Also, getting principal back early is viewed as an efficient way to eliminate risk. But market conditions are also a factor.

"It's impossible to do principal protection. If you're going to get into principal-at-risk, clients want to see things relatively short," the market participant said.

"Until we see a pop in credit spreads, a pop in rates, we'll continue to see shorter credits with high volatility and low dividend-types of indexes."

Unlike straight reverse convertibles, those autocallable deals allow the use of indexes as the underlying.

Some of the most commonly used indexes are their ETF version are the Russell 2000, the MSCI EAFE and some gold ETFs.

"People are trying to get some yield and are trying to get shorter terms. We see a lot of Russell and S&P with two underlying which increases the yield," the market participant said. He was referring to some of those deals structured around a worst of payout.

"You'll see more deals bullish on the structure with a flat or inverse forward curve. When the forward curve is downward sloping, you're going to get paid more. If the curve is in contango, a bullish view is going to look attractive because you're going against the forward. You're getting paid for that."

"Autocallables are popular. People like it because if it gets called, they get paid and they get their money back," the structurer said.

"They're much better deals than a plain callable note, which gets called at the issuer's discretion."

The autocallables may also offer alternatives to the traditional reverse convertible, he noted.

"They're less risky. The principal repayment is structured around a European-type of barrier, unlike the reverse convertibles. But you can get called during the life of the notes. So you have more chances of being right than wrong.

"I think demand for those [autocallable reverse convertibles] is driven by the need to stay short-term and to reduce risk. It's more risk-aversion-driven than yield-driven. A classic reverse convertible would give you more yield.

"You hope for a quick victory: You get your coupon, you get your money back and you move on."

"When priced correctly, people should appreciate the structure. And they do," he said.

Thomas Livingston, director of structured products at Halliday Financial Group, said that investors like automatic calls because they are reluctant to hold investments for too long.

"Everybody is looking for return right now, specifically those investors looking for current income," he said.

"We don't do reverse convertible right now because there's not enough return. You're better off owning the stock. With an autocall, you put the money out longer but you can be called sooner.

"Nobody wants to be locked in when the market changes quickly. There are more things that can go wrong in the next year than things that can go right," he said.

The average size of these reverse convertible autocallable deals was $1.5 million last week, with UBS selling nearly three-quarters of these under its trigger phoenix autocallable optimization securities brand.

However, Morgan Stanley priced the largest one - and the third one overall - with its $14.67 million of contingent income autocallable securities due Nov. 27, 2015 linked to the common stock of Apple Inc.

If Apple stock closed above a 75% barrier on a quarterly observation date, investors would receive a contingent payment of 3.0625%, otherwise, nothing. If the shares were greater than their initial price on a quarterly determination date, the notes were called.

At maturity, investors received par plus the last coupon if the final price was above the 75% downside threshold level; otherwise, they received a number of Apple shares equal to the principal amount of notes divided by the initial share price or, at Morgan Stanley's option, the cash value of those shares.

Leverage still popular

In volume, the market remained dominated by leveraged structures.

The top structure last week was a leveraged product with no downside protection. With five deals totaling $70 million in this structure type last week, last week's top deal of $50 million accounted for the bulk of these leverage-type deals with full risk exposure.

Goldman Sachs Group, Inc. priced $50 million of 0% leveraged index-linked notes due Dec. 6, 2013 tied to the S&P 500 index. The upside leverage factor was three times; the cap was 19.47%; and investors were exposed to any losses.

For the year to date, leverage with no protection has declined in volume by 28% and represents 15% of the volume. Leveraged notes with a buffer or barrier have remained flat and make for 21% of the volume.

All asset classes declined last week with the exception of FX due to a larger-than-usual currency-linked note offering also issued by Goldman with JPMorgan acting as a placement agent.

Second in size for the week, Goldman Sachs' $25 million of 0% currency-linked notes due Dec. 4, 2013 linked to the Mexican peso relative to the dollar were part of a series of recent deals built around the Mexican peso and using the same structure, all of which have known some success, according to the data.

Goldman Sachs was the top agent last week with $83 million, or 41.54% of the total, in 14 deals. It was followed by JPMorgan and Morgan Stanley.

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