Volume up 13.4% for year shows investors find structured notes still useful in toppish market

By Emma Trincal

New York, Sept. 17 – If September volume indicates a slight slowdown from August, year-to-date action remains strong compared to 2013, according to data compiled by Prospect News. On a year-to-date basis, agents have sold $29.76 billion as of Sept. 12, a 13.4% increase from last year.

The $875 million sales for the first half of September represent a 6.5% decrease from the same period in August. Meanwhile, this month to date has recorded a 43% uptick from last year.

Sources said that with the bull market still on but showing signs of weakness, investors are more than ever interested in replacing some of their equity investments with structured notes.

Hot summer

“July and August, which are typically our slowest months, didn’t turn out that way this year,” a sellsider said. “Actually, July was our best month ever. Not necessarily because of one or two big deals but due to a lot of little deals. We did triple of what we did last year. We had in July a fair amount of bonds that were called, but it wasn’t the case in August.”

July was the second-best month of the year in volume after January, the data showed. August was the fourth one after February.

“September is starting out a little slower than August, but I think it’s going to be a very good month. When we talk to our advisers, we note the recurrent theme of downside protection as something that clients are focusing on in order to achieve their growth, income and risk-tolerance goals,” the sellsider said.

The S&P 500 has been in a bull cycle since the trough of March 2009, with the rally gaining strong momentum last year. While the uptrend has decelerated this year, the market has continued to reach new all-time highs.

Sources said this type of market cycle and uncertainty is favorable to structured notes issuance.

For bulls too

“It’s not just when the market is volatile that you get people to invest in structured notes. The solid summer we just had characterized by the market reaching new highs almost week after week shows that those products may be useful in a bull market as well,” the sellsider said.

“Maybe that’s what’s going right now in terms of volume. We can see people moving a portion of their equity portfolio into structured notes.

“For instance, one of our advisers told us about a client who worried about the big run-up in the market and said, ‘Well, maybe it’s time to move into cash.’ Three years ago he said that. Our adviser told him that instead of moving into cash, he could look into a principal-protected note, that way, he could keep his equity exposure and protect his principal.

“When equity prices move that high, your portfolio is out of balance. Equity is out of proportion. The logical thing to do in normal time is to sell some equity to buy bonds. But with the bond rally that we had, that asset class is not necessarily going to reduce your risk as it traditionally has. Besides, yields are so low you’re not going to benefit much from a fixed-income allocation in terms of income. Perhaps moving into a structured note is a better option.”

Flexibility

Tom May, partner with Catley Lakeman Securities, said that one of the drivers behind issuance growth is the flexibility of use offered by structured products.

“Structured products can do a lot of things and serve very different needs in different markets,” May said.

“I would guess that people use the more defensive products in down markets and the more aggressive ones in bull markets.

“I haven’t checked, but it’s likely that return-enhancement notes sell well in bull markets while notes with limited upside and good buffers may do well during volatile times.

“Maybe the best thing to do would be to go the other way around in anticipation of a market turn.

“I’m not sure which way it’s going, but we’re definitely seeing demand in this bull market.

“What we’ve seen a lot is clients who have stayed on the sidelines for a while saying, ‘I have a lot of cash, I’ve been liquid long enough, it’s time to put some money in the market.’ Those clients are likely to buy some structured notes to keep some level of protection instead of being long-only.”

Volume has also benefited from an increase in the number of offerings this year, including big offerings.

Agents so far this year have priced 6,440 deals, a 16% increase from 5,540 in the same period of 2013.

The number of deals in excess of $50 million has also increased to 66 from 54 last year, according to the data.

Two-thirds in stocks

Stocks prevailed last week with two-thirds of the volume made of single names. About 40% of the volume came from autocallable reverse convertibles, but those were smaller in size, mainly under $2 million. The top of the list, however, showed more diversity in the structures being used.

The volume of single-stock deals (two-thirds of the total) greatly exceeded the year-to-date average of 30%, according to the data.

“It’s hard to say why you get an uptick in single names unless things were getting called and rolled,” May said.

Top deal: $90 million

The No. 1 offering was not a very common structure, sources said.

JPMorgan Chase & Co. priced $90 million of 8% equity-linked notes due Sept. 18, 2015 linked to the common stock of Bank of America Corp., according to a 424B2 filing with the Securities and Exchange Commission.

Interest is paid monthly.

If the final stock price is less than or equal to the lower put strike price, 85% of the initial strike price, the payout at maturity will be the 90.49774% downside participation rate times the lower put strike price.

If the final price is greater than the lower put strike price and less than the upper put strike price, 110.5% of the initial strike price, the payout will be 90.49774% of the final share price.

If the final price is equal to or greater than the upper put strike price and less than the call strike price, 112.88% of the initial strike price, the payout at maturity will be par.

Finally, if the final price is equal to or greater than the call strike price, the payout will be par plus (a) 0.65 times (b) the final share price less the call strike price.

“We’ve seen those types of deals done before from Morgan Stanley,” the sellsider said.

“You apply a factor to the downside. If the return is negative, you apply a multiplier to that.”

In last week’s structure, the factor was 0.9 and the barrier 85%. A 20% decline in the underlying price would lead to a 23.5% loss – the barrier level multiplied by the factor – but the loss would be capped at that amount, according to the prospectus.

Leverage on stock

In the No. 2 offering, the issuer applied a simple leverage payout using a single name.

Barclays Bank plc priced $39.84 million of 0% Accelerated Return Notes due Sept. 28, 2015 linked to the common stock of General Motors Co. The deal has no downside protection. The upside leverage factor is three and the cap 23.85%.

“A pure leverage play,” the sellsider said.

“Bank of America does them. UBS, I know, does tons of them. It’s just a simple leveraged note with no downside protection, usually very short-term.

“We haven’t offered these to our retail clients, not that they wouldn’t get approved on our platform. Maybe it’s my personal influence. I think that people should use structured notes for the downside protection, not necessarily for the leverage.

“Obviously you can structure them. You’re short an at-the-money put, which gives you the one-to-one downside, and you’re long three call spreads. Using a stock gives you more premium from the put sale as you extract more volatility.

“As an investor, if your view on the stock is bullish and if you think that performance will be limited inside the cap, you can outperform a direct investment. I just think structured notes are not the right venue to do leverage. In my view, the more appropriate use is to provide some kind of downside protection.”

No. 3

The third top-seller, also based on a stock, was one of the few large autocallable reverse convertibles.

HSBC USA Inc. priced $22.27 million of contingent income autocallable securities due Sept. 17, 2015 linked to 3D Systems Corp. shares.

The notes pay a contingent quarterly coupon at an annual rate of 15.5% if the stock closes at or above the 65% barrier level on a quarterly date.

The notes will be called at or above the initial price on a quarterly basis.

If the notes are not called and the stock finishes at or above the downside threshold level, the payout at maturity will be par plus the final coupon.

If the stock finishes below the barrier level, investors are fully exposed to the decline.

Morgan Stanley Wealth Management was the dealer.

“These are the typical phoenix autocallables. The market, including ourselves, is doing more and more of that,” the sellsider said.

Phoenix autocallables are contingent coupon-paying investments with an autocall trigger usually set at a different level than the coupon barrier.

They differ from traditional reverse convertibles, which pay a fixed coupon and are not callable.

Straight reverse convertibles represent about 2.5% of the total volume this year, compared with 20.85% for callable reverse convertibles, according to the data.

Phoenix rising

“We don’t do much of that reverse convertible business anymore. Most of the business has switched toward the phoenix, the autocallable features, which allow for bigger barriers. You get a little bit more downside protection than what a straight reverse convertible would give you,” the sellsider said.

“Since there is more risk with the call and the contingency, you can get a higher coupon than a reverse convertible. But you don’t have to use it that way, and most of the time, the extra premium is used to provide more protection.

“These advantages explain why people have massively moved from traditional reverse convertibles to these autocallable notes.”

JPMorgan doing JPMorgan

JPMorgan was the top agent last week with 18 deals totaling $155 million, or 36.30% of the total. It was followed by UBS and BofA Merrill Lynch.

JPMorgan’s high market share may compare to that of BofA Merrill Lynch when the latter prices most of its deals at the end of the month, according to the data.

But 21% of the week’s volume came from JPMorgan’s top deal, which explains in part its strong showing, sources noted.

More unusual, they said, was the high proportion of JPMorgan deals issued by the bank itself, 15, versus three offerings distributed by JPMorgan but issued by Deutsche Bank.

“Some issuers from a credit standpoint have a lower credit than JPMorgan, so they have to diversify that issuer’s risk by going to other credits,” the sellsider said.

“Maybe clients of JPMorgan feel comfortable with the bank’s credit and therefore JPMorgan may not have the same incentive to open their platform and show different issuers as other firms do.”

JPMorgan’s five-year credit default swap spreads at 54 basis points are among the lowest in the United States after Wells Fargo, according to Markit. In comparison, Goldman Sachs and Morgan Stanley have spreads of 78 bps and 75 bps, respectively.

“September is starting out a little slower than August, but I think it’s going to be a very good month.” – A sellsider

“We’re definitely seeing demand in this bull market.” – Tom May, partner with Catley Lakeman Securities

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