Outlook 2013: Clients to look for structures striking balance between yield and risk

By Emma Trincal

New York, Dec. 31 - Structured products investors will continue to look for yield and protection but they will have to adjust to the realities of lower interest rates, sellsiders said.

It will take a combination of innovation on the part of issuers and changes in clients' expectations to find the right balance between risks and rewards.

Protection

Incapital, a fixed-income distributor, in a survey released in December, predicted that structured notes are likely to surpass structured certificates of deposit in popularity in the coming year.

"The share of principal at risk structures is likely to increase, as investors see the benefit to tailor-made investment exposure according to their expectations instead of simple delta one exposure to the underlying," said Bernd Henseler, vice-president, structured products at S&P Dow Jones Indices.

The Incapital survey, which polled nearly 100 financial professionals, found that the majority of respondents believed that non-principal protected notes specifically, as opposed to principal protected notes and CDs, had the most growth potential among investors of all structured products in the near future.

"Investors will look to structured products to provide protection on tail risks -defined as 10% risk of happening," said Ray Doherty, director, cross asset solutions & strategies at Bank of America

Autocallables

A possible trend may be to use a successful payout structure seen in one asset class and to transfer it to another asset class.

"In recent years we have seen almost every payout variation possible," said Henseler.

"One part of innovation should be applying established equity payouts in the equity space like barrier or autocallables to other asset classes."

He sees payouts like barrier and autocallables becoming more prevalent than others.

Autocallables, in particular, he said, are popular for their "predefined" payout.

"If the underlying price reaches a certain level, you know that you'll get your payout. It makes it very easy to explain," he said.

"I also expect variations of barrier structures linked to single shares and equity indexes to do well.

"We will increasingly continue to see the trend toward smaller issuance sizes," he said.

Reverse convertibles, which also sell volatility, have not done as well though.

"Although they're similar to autocallables, they're not as clear-cut to explain," he said.

"If reverse convertibles have declined in 2012, I can only speculate that it was related to the market. When you get double-digit returns from the market, people focus more on participating in the upside."

Some structures may become more popular this upcoming year in response to low yields, especially if the market trades sideways.

"Digital structures should do well in 2013. These trades did very well last year. A lot of them will mature in 2013 and they're likely going to pay out well," Doherty said.

"These are products where investors will likely continue to roll money into based on the positive experience of 2012 returns.

"I also expect to see growing demand for dual directional or other products designed to express a range bound view of the market," he said.

Leverage, which represented more than a third of 2012's volume, according to data compiled by Prospect News, is likely to remain a favorite.

"In the institutional space, clients will continue to look at leverage as a more efficient way to get exposure to an index or a fund," said Doherty.

Triggers

JohnTessar, senior vice-president, head of structured products at JVB Financial Holdings, said that trigger notes have been popular in the past year. Their demand should continue to grow in 2013.

"You have to strike a very delicate balance between getting ongoing yield, or a coupon flow through the life of the product, and obtaining a product that rewards you later at maturity," Tessar said.

"An investor wants to combine some reward during the life and a final payout at maturity. As a result, some of the most popular structures have been the trigger-types of notes. They're designed to get some yield pickup.

"People are very interested in them," he said.

"More people are willing to take some form of principal at risk as long as they're getting some income flow in the interim. Those trigger notes also have the advantage of being easy to understand. Our entire industry likes the idea of simplicity but we don't do enough of it," he said.

"If you are above 80% at the observation, you get the coupon, and if you end up above 80% at maturity you get your money back."

The growing interest in trigger notes is occurring at a time when the appetite for reverse convertibles has diminished. But many of those trends can be cyclical.

"Reverse convertibles have fallen off. They will definitely be back though. But right now, they're out of favor. There's too much downside risk potential. People don't believe that what they receive is worth it," he said.

High net worth

Popular structures vary with the type of clients, said Serge Troyanovsky, managing director and head of retail distribution North America at BNP Paribas' Structured Solutions Group.

Each market segment, according to him, shows different types of products for different types of investors, citing for the U.S - private banking; retail; and registered investments advisers.

In the private banking and wealth management sector, he said, high-net-worth investors are looking for "value-added" products.

"They want participation in the underlying with some leverage or some added participation like the step-up," he said.

"Products may or may not have downside protection because clients in this category want to extract value from the underlying in a rising market or even in a range bound market."

Income

Retail investors, on the other hand, are more comfortable with CDs, he noted.

"Clients in this space are more reluctant to participate in the market," said Troyanovsky.

"They want the opportunity to get a rate in excess of today's very low interest rates. CDs and principal-protected notes have been extremely popular with these clients.

In the retail network, built around broker-dealers, larger regional banks and distributors outside the wirehouses, clients ideally seek the highest coupon and the maximum protection.

"In many cases, they'll get something in between," he said, "not the full principal protection but the opportunity for a higher potential coupon."

One of the "something in between" features, he said, were the "low barrier" notes.

Firms, including BNP Paribas, introduced those products in 2012, and their success is likely to extend to the coming year, he predicted.

Low barrier

"The barrier is set at a fairly low-level at 55% to 50% in some cases. This is a significant contingent downside protection. If you look at how the underlying performed historically, in many cases you wouldn't see such a 50% decline. We try to develop good level of downside protection, but we don't eliminate risk entirely: the client still has downside exposure. However it allows us to pick up substantial yield," he said.

Investors with these products get one final observation at maturity, which is more popular than the American-type of barrier, he said. The tenor may vary from 18 months up to five year. The notes may or may not be callables and their coupon could be fixed or inversely, based on the performance of the underlying. The underlying may consist of one or two indexes or funds, sometimes associated with a worst of payout. At maturity, investors get their principal back unless they hit the trigger.

"Those products are becoming more and more popular because the low and European-style barrier reduce the risk significantly," Troyanovsky said.

Buffers, algorithms

Finally at the RIA level, investors often show appetite for two different types of products - one that has become customary and the other representing the cutting edge of innovation.

"The first one is the simple buffered note. It has become the standard instrument in the construction of a portfolio. Advisors look for those products to get exposure to a specific market," he said.

A perfect example this past year has been the pricing from various issuers of two-year notes tied to the EAFE index with some downside buffer and upside leverage up to a cap, he said.

"If you need that type of exposure, this particular type of structure has become the instrument of choice," he said.

The other typical instrument used by RIAs, often as a hedge, is the structured note tied to an algorithm index.

"RIAs are looking for strategies that would provide potential hedges for the portfolio in case of significant market declines. They're looking for some form of portfolio insurance," he said.

One particular application has been to improve volatility instruments.

"Trying to help investors benefit if there's a spike in volatility, yes, it's a great idea, but the big question is how do you introduce it in a portfolio and keep the cost under check? If you're long volatility and volatility does not move up, how do you manage your position without incurring too much pain and still be ready to benefit from a sudden volatility spike? That's when algorithms can be very beneficial," he said.

Asset classes

Algorithms can be used in other asset classes too in order to solve some technical problems at a lower cost.

Commodities-linked notes could benefit from innovative indexing, said Henseler.

While those notes saw their volume decline by half last year, he remains optimistic.

"Commodities should be in demand because they offer a hedge against inflation and more diversification," he said.

"Innovations have led to address some of the most vexing issues associated with commodities investing, such as negative roll and contango."

The S&P GSCI Dynamic Roll index for instance, he added, one of the first dynamically rolling commodity futures index, has been used in several ETNs, ETF's, structured notes and market linked CDs since its inception in January 2011.

The market however will continue to remain heavily weighted on equity underliers. In the past year, equity-linked notes issuance accounted for 76% of the total volume, including single-stocks, stock baskets and equity indexes.

Incapital in its survey found that adding equity exposure to the portfolio was for 34% of its respondents the primary reason to use structured products.

"Equity and in particular equity index products should bring in the main volume, with an increased focus of single share and emerging market exposure," said Henseler.

Plain vanilla growth

While sales of traditional interest-rates notes have collapsed in volume last year, down nearly 90% from the previous year - the separate plain-vanilla fixed-income products category, including step-up notes, step-down notes, fixed-to-floating notes and capped floaters, has seen its volume grow by almost 10% last year.

Sources said they were optimistic about this sector of the market.

"Longer-dated fixed-income products that feature a variable coupon could potentially see an increased demand, as investors want to participate in potential upside interest rate moves and hedge against inflation," said Henseler.

The bid on those products in 2012 helped offset some of the decline observed in the more traditional market-linked investment products, such as equity-linked notes and principal-protected notes, according to Cary Immesoete, managing director, head of product development and marketing, Customized Investment Solutions at Wells Fargo Securities.

"For us, the popular structures in 2012, those where we saw real growth, were products that give clients alternatives to vanilla fixed-income products," he said.

"For us, the fixed-income growth story was a very positive surprise. It was definitely one of the areas of growth in 2012. As investors continue to seek yield, I expect these simple fixed-income products to continue to grow in volume in 2013," he said.

The new frontier

Finally, a new type of structured investment, still new but very innovative, should deserve the attention of advisers, sources said as it could open the door to a more mainstream industry. These products sold as funds under the 1940 Investment Management Act offer advantages similar to a structured note by using derivatives technology and options to customize a particular strategy or risk profile. The difference is that they are not notes.

Eaton Vance launched in January its eUNITs trust tied to the S&P 500, a closed-end fund using derivatives in a 1940 Investment Act instrument. The eUNits came on the heels of AAM's Multi Enhanced Return Investment Trust, High 50 October 2011 series in 2011, a unit investment trust, created at the end of 2011.

"One of the key components of this new frontier of 1940 Investment Act instruments with structured-product-like functionality is that 40 Act investors are not taking the full credit risk of a structured note issuer. That's the most important part," said Samson Koo, managing director, head of derivative products at Advisors Asset Management.

"Additionally you have other significant advantages such as transparency and liquidity.

"These new products are not mainstream yet. But eventually, things will move in that direction," he said, adding that he is aware of a number of firms working in that direction.

The concept is so new that few advisers are aware of the potential, he said. "It takes time for investors, advisers and distributors to fully understand and accept those new products," he said.

"But once they realize that they can achieve structured products-like functionality without taking full credit risk of structured note issuers and with meaningful improvement in transparency and liquidity, I think they will embrace the concept. This is a new frontier," he said.

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