Volume drops ahead of holiday; investors trade protection for upside leverage

By Emma Trincal

New York, Sept. 7 - Volume fell to $442 million in 91 deals in the week ahead of Labor Day, down 54% from the week before.

"Most deals priced the week before, because people tend to be out before Labor Day," a structurer said.

"Past Labor Day is when people get back to things. So I anticipate that this week will be better even though it's the beginning of the month."

"The drop last week is all likely due to the calendar," a market participant said.

"Historically, the last two weeks of August replicates the slowdown seen in Europe during that month."

Leverage, leverage

The most popular structure employed last week remained leverage, with a switch toward unprotected deals, according to data compiled by Prospect News.

Agents sold $124 million of leveraged notes without downside protection. These deals made up 28.13% of the week's total volume.

Leveraged products with a barrier or a buffer amounted to 26.56% of the total at $117 million.

The difference in volume between the two categories was slim. However, enhanced notes with no downside protection rose 47% while leveraged notes with downside protection declined in volume by 42%.

Since the beginning of summer, investors have favored leverage with no downside protection, according to data compiled by Prospect News.

However, they have sought barriers and buffers recently as a result of the sell-off.

Sources said investors have been seesawing between unprotected and protected leveraged notes along with the ups and down of the market.

Sources interpreted the pendulum as a sign that investors are still trying to tap into opportunities while struggling with fear in an uncertain market environment.

Pricing conditions linked to volatility moves were a factor that influenced decisions.

"When you get a downturn like in August, the volatility spikes make it easier to price notes with a buffer," said the structurer.

"You get more to sell out-of-the money puts, and the pricing for the downside is also cheaper," he said.

"Those products look more attractive; you get more upside. Investors go for it not so much because they're afraid but because they can get it at a reasonable price."

The sell-off presents good opportunities as well, the structurer said.

"The price pullback in the index creates bargains," he said.

"The downside protection comes in the form of a lower entry point."

Fear factor

The switch on the part of investors between partial downside protection and full exposure to losses has a lot to do with market sentiment, said the market participant.

"In the early days of August when volatility spiked, there was a lot of fear in the market," he said.

"You saw a movement toward more protection in the days after that, toward the middle of the month.

"Then at the end of the month, that fear dissipated a little with Warren Buffet investing in Bank of America. A lot of people started to think that the volatility spike was just a short-term thing and that maybe it was not 2008 all over again."

This market participant said that the push for leveraged structures giving more upside at the price of less protection may just be a reflection of this reduced level of fear. But he expects the trend to be temporary and the outlook to become more bearish again.

"I think you have a mix between fear and the sense that the market offers new opportunities.

"But I see fear coming back, and I'm sure investors are going to turn to deals that offer buffers again," he said.

He cited the disappointing U.S. jobs data on Friday and the ongoing weakness across the eurozone taking the form of a strong sell-off in the European markets on Monday and Tuesday.

"The head of Deutsche Bank gave a very pessimistic speech on Monday. And he's perhaps the most respected banker in Europe. I think there will be more uncertainty and volatility looking forward," he said.

Reverse convertibles declined last week, down 13% at $84 million. They amounted to 19% of the total, versus 10% the week before.

All asset classes declined last week, but equity remained on top and dwarfed other categories.

Equity deals represented 86% of the total with $379 million but declined by 50% from the prior week.

Equity index-linked notes continued to lead with 64% of total volume while the appeal of stocks was more muted. They made up 22% of the total.

Among the asset classes to drop the most were rates-linked products, down 93%, and commodities, down 81%.

Exchange-traded funds represented the underlying asset class that held up best. They were down only 1% and amounting to $28 million for about 6% of the volume.

Among some of the most popular ETFs used as the underlying of offerings last week were the SPDR S&P Metals & Mining ETF, the iShares Russell 2000 index fund, the iShares MSCI Emerging Markets index fund and the United States Oil Fund, LP.

Top deals

The top deal of the week offered three times leverage and full exposure to losses.

Royal Bank of Canada priced $66.19 million of 0% Accelerated Return Notes due Oct. 26, 2012 linked to the S&P 500 index. The cap is 18.39%. Bank of America Merrill Lynch was the agent.

RBC did several notable deals with Bank of America Merrill Lynch. RBC also worked with UBS - notably on an autocallable note linked to Google Inc. - as well as Wells Fargo.

"This is a case of open architecture," the structurer said about RBC. "I know they've been working on it for a while; they've been trying to expand. They're finally getting out there with it and putting it to work."

The second largest deal was Goldman Sachs Group, Inc.'s $54.44 million of 0% leveraged index-linked notes due Oct. 28, 2013 linked to the S&P 500 index with 1.5 times leverage, a 15% buffer and a 40% cap.

Leverage multiples in some cases were high, as with the third largest offering: Goldman Sachs' $29.85 million leveraged notes linked to the S&P 500. They have a four times multiple on the upside with a cap of 44% and no downside protection.

"It looks like this type of deal would be for an institutional investor or family office or perhaps very, very high-net-worth," the market participant said.

"We do strictly retail, and we wouldn't be selling that."

Goldman Sachs topped the weekly league tables with $130 million sold in nine deals, or 29.33% of the total.

It was closely followed by Bank of America Merrill Lynch with $124 million in six deals and by UBS, which priced $92 million in 37 offerings.

Morgan Stanley was the No. 1 agent the week before.

For the year to date, JPMorgan takes the first slot with $5.58 billion.

Figures in this report do not include exchange-traded notes.

"The price pullback in the index creates bargains." - A structurer

"... I'm sure investors are going to turn to deals that offer buffers again." - A market participant

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