Focus is on access, theme rather than structures amid tough pricing conditions, sources say

By Emma Trincal

New York, June 25 – Volume continued to be thin during the third week of June at $352 million in 94 deals, versus $577 million in 135 deals the week before, according to data compiled by Prospect News.

As the summer kicks off and volatility hits new lows, issuers are shifting gears and focusing on themes, access or stock picks rather than on structures that are getting harder and harder to price, a sellsider said.

This view is confirmed by the growing volume of equity-linked notes that provide no optionality but rather direct access to a particular theme, asset class or systematic strategy.

Last week’s two largest deals suggested that thematic deals may have gained more appeal. One is linked to a company that delivered headlines and the other to a hard-to-access equity index.

Underlying focus

“I think you see more and more interest around theme investing when it comes to structured products,” the sellsider said.

“We’re seeing a lot of notes tied to smart beta indexes. In Europe, they’re going one step further in putting together structured notes tied to socially responsible investing. It’s very trendy over there, and I wouldn’t be surprised if it became a trend in the U.S. as well. In fact, it may become a trend soon.

“Let’s be honest: I haven’t seen any disruptive innovations in terms of how people structure deals. Structures are slightly boring in today’s pricing environment.

“A couple of years ago, all the excitement was around payouts: the leverage, the barriers, the level of the caps. Now many of the traditional structures have become plain vanilla. If you’re an issuer and want to offer a value proposition to your client, you have to innovate on your underlying.”

He gave a few examples.

“In some cases investors want access to an index which is not available in an exchange-traded fund format. Other times, they may look for trackers tied to smart beta indices giving them access to a systematic strategy. Other times, it’s an alternative to an option strategy on a particular stock,” he said.

Big bet on Medtronic

The week’s largest deal was Credit Suisse AG, Nassau Branch’s $99 million of 8% equity-linked notes due June 23, 2015 linked to the common stock of Medtronic, Inc. The medical device maker was in the news last week after it announced the purchase of Dublin-based Covidien plc. The Minneapolis-based company expects to save billions in taxes by relocating to Ireland.

The notes offer a fixed coupon plus some participation rates that vary based on where the final share price falls in relation to lower and upper put strikes.

“This may have been a deal done in relation to the headline,” the sellsider said.

Some analysts said the name drew a lot of attention.

“The stock has been trading in a pretty steady range since the announcement last week between $63 and $65,” said Debbie Wang, a Morningstar analyst who covers Medtronic.

She noted that investors reacted positively to the acquisition news story.

“When a company decides to acquire another one, its share price may drop – although not always, depending on what they buy and what price they’re paying for it.

“It hasn’t been the case here. First of all, Covidien is a high-quality company, and secondly, Medtronic’s decision to reduce its tax burden is seen as a very positive development that will free up a lot of cash. Investors like it.”

Joe Bell, senior equity analyst at options shop Schaeffer's Investment Research, said that bulls are gravitating around the stock.

“In the past 10 days, we’ve seen a call-to-put ratio of 5.39. That means more than five times as many calls than puts have been purchased to open. That ratio is pretty high on a historical basis. Option speculators are buying a lot of calls. They’re pretty bullish on the stock right now,” he said.

Customized

While the deal is linked to a well-publicized name, a structurer said that the product is more about “structure” than “access.”

“It’s a strange structure, but it’s a pretty customized structure. It may have been introduced around the news that broke last week but not necessarily intentionally,” this structurer said.

“I don’t think it was done based on a theme or story around the name, although it’s definitely a directional bet. You have a fairly bullish bet. It’s a put spread, so you’re not taking all of the downside risk, you have downside protection against a crash. If the stock rallies, you have some of the upside plus the coupon. This is a big deal, but I doubt that it was marketed around. That’s for a specific client, at least that would be my guess.”

The No. 2 deal last week, HSBC USA Inc.’s $33.5 million of 0% notes due Sept. 23, 2014 linked to the Topix index, is an example of an “access” product as the underlying is not available to ETF investors. The underwriter was HSBC Securities (USA) Inc.

As with other agents who create notes linked to this Japanese benchmark on a regular basis, notably Goldman Sachs and JPMorgan, HSBC sold a delta one product.

“The pricing environment is so challenging right now, rates are so low, volatility keeps on going down, it’s starting to make sense to use thematic baskets, indexes just to give investors access to a particular strategy or asset class. These deals are less sensitive to pricing parameters. You can wrap a delta one product around one theme,” the structurer said.

New lows

Volatility hit new lows last week. On Wednesday, the CBOE Volatility index, or VIX, which measures implied volatility on S&P 500 options, closed at its lowest level since February 2007.

The volume of structured products issuance has grown 14% to $19.58 billion for the year through Friday from $17.18 billion during the same period of last year.

“We keep on hitting all-time highs in the equity markets. It helps to drive up volume,” the sellsider said.

However, others see the pricing environment as a drag on issuance and believe the bullish environment has not driven enough investors into the structured products space to offset the negative impact created by low volatility and rates.

“While business has been steady, not great but steady, the pricing environment is tough. The market has continued to rally, but people are less certain about where it’s going from here. People are still waiting,” the structurer said.

Equity-centric market

Equity has grown as a percentage of total volume. It represents 82% of the market versus 77% last year, the data showed.

Low volatility has led some issuers to create highly leveraged notes.

Several small issues with five-times leverage have been seen lately, according to the data.

For instance, Morgan Stanley priced last week $5 million of 0% return optimization securities due June 20, 2019 linked to the FTSE EPRA/NAREIT Developed Europe index. Investors have five-to-one upside and one-to-one downside. There is a 75% cap.

Stocks prevailed last week, making for 55% of the total volume versus 27% for equity indexes. It is the reverse proportion seen for the year to date, according to the data.

“Single stocks have always been the focus of many people’s interest,” a market participant said.

“Perhaps you see more stocks because they’re simply different. You can only create so many products on indexes. You get to a point of exhausting your index structuring capacity,” he said.

The higher volatility found with stocks has made autocallable reverse convertibles one of the structures of choice for many investors. This product category represents 20% of the total volume this year.

One example of such product last week was Morgan Stanley’s $16.98 million of contingent income autocallable securities due June 25, 2015 linked to Twitter, Inc. It was the fourth deal in size.

Rates-linked notes have also become more popular, growing 55% this year to $1.10 billion, according to the data.

Citigroup Inc. last week priced $15 million of CMS spread notes due Dec. 19, 2017 linked to the 30-year Constant Maturity Swap rate and the five-year CMS rate. The first-year fixed interest is 3.25%. After that, investors receive the spread minus 50 basis points, subject to a cap of 3.25% per year.

The top agent last week was Credit Suisse pricing three offerings totaling $105 million, or nearly 30% of the total. It was followed by JPMorgan and Morgan Stanley.

“Structures are slightly boring in today’s pricing environment.” – A sellsider

“You can only create so many products on indexes.” – A market participant

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