Downside barriers, contingent minimum return notes should pick up momentum as volatility soars

By Emma Trincal

New York, May 23 - Agents are increasingly offering deals with downside barriers and contingent returns, a direct result of rising levels of volatility, sources said.

"When you have a downside barrier, the more volatility, the greater the potential coupon because it's more likely that you're going to hit the trigger," a sellsider said.

"The client sells volatility with those barrier options. The more volatile your underlying asset is, the higher the coupon you're extracting."

Whether those deals take the form of knock-outs guaranteeing a contingent minimum return if the downside barrier is not breached or absolute value structures giving investors a positive return even when the underlying declines as long as the downside threshold is not crossed, deals following this pattern are getting increasing attention from investors, according to sellsider sources.

"With a contingent coupon, you get something unless something happens or unless something does not happen. You know the conditions up front," a structurer said.

"Your minimum contingent return will be higher when volatility is high.

"If volatility was low, you'd have a lower chance of hitting the barrier. In order to keep the same coupon, you would have to put the barrier up."

VIX up

Rises in volatility give issuers the choice between offering higher upside and more downside protection, or sometimes a little bit of both, this structurer said.

"It really depends on the investor," he said.

In any event, volatility spikes offer more leeway for the pricing of deals that compensate investors by selling put options, he said.

Since its low of March 26 at 14.26, the CBOE Volatility index, or VIX, has soared to its highest level for the year on Friday at 25.10.

More deals with downside barriers and contingent payouts should follow as a result, sources predicted.

"You know that you get a specific return under specific conditions," said the sellsider regarding contingent payouts.

"If a knock-out is not triggered, you know that you're going to get something, whether it's a premium, a coupon or an absolute value payout.

"I think people like it because it provides them with some kind of direction in a very uncertain market."

Two recently priced deals illustrate the trend.

Knock-out

The first one is a knock-out product with a contingent minimum return.

JPMorgan Chase & Co. on Friday priced $30.23 million of 0% capped index knock-out notes due June 5, 2013 linked to the S&P 500 index, according to a 424B2 filing with the Securities and Exchange Commission.

A knock-out event occurs if the index falls by more than 23.5% from the initial level during the life of the notes.

If a knock-out event has not occurred, the payout at maturity will be par plus the greater of the index return and the 5% contingent minimum return.

If a knock-out event has occurred, the payout will be par plus the index return.

In either case, the maximum return is 15%.

"With the knock-out product, you sell the barrier at 23% below the spot," the structurer said.

"If volatility is high, the model will assume that the barrier can be breached. Investors will want to be compensated for the risk and they can get a higher coupon. Alternatively, if the coupon is not raised, the investor may get a lower barrier further away from the initial price."

The structurer noted that one way to construct this type of structure is through the sale of a down-and-in put.

"When this barrier option is hit, when you're down by more than 23%, you get assigned the stock. You're long the S&P 500. You lose the benefit of the contingent minimum, which was also what guaranteed your protection," he said.

"If you know that you're going to get at least 5% even if the index falls by 23% as long as it doesn't fall by more than that, it's attractive," the sellsider said.

"People see it as an income opportunity and also as a way to participate in the index.

"You're not capped by the contingent minimum return. It's an attractive package in a range-bound market."

Absolute return

The other structure, which also priced on Friday, is a deal combining a call feature with an absolute value contingent payout.

Deutsche Bank AG, London Branch priced $7.5 million of 0% contingent absolute return autocallable optimization securities due May 28, 2013 linked to the common stock of Caterpillar Inc., according to a 424B2 filing with the SEC.

The notes will be called at par of $10 plus an annualized call premium of 19.5% if Caterpillar stock closes at or above the initial share price on any quarterly observation date.

If the notes are not called and the final share price is greater than or equal to the trigger price, 75% of the initial share price, the payout at maturity will be par plus the absolute value of the stock return. Otherwise, investors will be fully exposed to the stock decline.

UBS Financial Services Inc. and Deutsche Bank Securities Inc. were the agents.

"These are called phoenix. The callability is worth something because of the uncertainty," the structurer said.

"The higher the volatility, the more coupon [or call premium] you can give for each quarter.

"They're also called memory coupons because although you may miss a coupon the first time, you can get it at the next date. It remembers the first coupon and adds to it," he said.

For instance, an investor who would miss the first 4.875% payment on the first quarter (based on the 19.5% annualized return) may get the equivalent of the two quarterly payments on the second observation date at 9.75%.

The sellsider said that the product is innovative.

"You have an autocallable with an absolute value component in this structure. I haven't see that much of that. It looks like a new product to me. Usually you either have a callable feature or the absolute value thing. But combining the two in one product suggests a new direction," he said.

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