Mid-week Fourth of July, early month cycle, market uncertainty put structured products on hold

Emma Trincal

New York, July 11 - The combination of a Fourth of July in mid-week, a slow summer pace and a struggling structured product market facing difficult pricing conditions and spooked by regulatory scrutiny contributed to an exceptionally slow week, sources said.

Agents sold only $96 million during the week ended Friday in 40 offerings, according to data compiled by Prospect News. The top deal size was short of $14 million.

"That's small. But I would be careful in drawing strong conclusions," a structurer said.

Volume was down 70% from the $331 million sold in July 1-7 of last year. However, an important difference was that last year's Fourth of July holiday fell on a Monday.

Happy Fourth

"Having the Fourth of July in the middle of the week really didn't help. It had quite an impact. A lot of financial advisers were out through the week or after. There were a lot less people to talk to the end client," a sellsider said.

"Industry-wise though, the weakness we experienced in June seems to continue. Across the broker-dealer spectrum, sales in all products, not just structured notes, dropped dramatically in June.

"The combination of low volatility and low interest rates makes the pricing of deals less attractive.

"And you have the market. People every day turn on to CNBC, Bloomberg and hear about Europe, U.S. unemployment. They're not sure what to do.

"What you see is a drop in new money. People who know structured products, who are shopping for deals are still looking. But for those who thought of entering the market for the first time, it's a different story. They're not allocating to stocks or bonds. So it's not as if they were going to make first-time allocations to structured products."

A market participant agreed that the holidays played their part among other things.

"Last year, the Fourth of July was a Monday. People took the two days off last week," he said.

"You also had news coming out: the European Central bank cuts, a disappointing job report in the U.S.

"I wouldn't call it a trend. Let's see what's happening in the next two weeks."

The year-to-date trend is not really comforting, however.

As of July 7 of this year, agents have sold $19.55 billion in 4,327 deals, an 18% decline in volume compared to the same period last year, which saw the pricing of 3,254 deals totaling $23.82 billion, according to Prospect News data.

"The regulatory concerns have an impact on sales," the structurer said.

One example sources often cite is the drop in volume for reverse convertibles, which are down 19% from last year, according to the data.

The Financial Industry Regulatory Authority issued a new investor alert on Tuesday on exchange-traded notes called "Avoid Unpleasant Surprises." As a result, some market participants have already begun to worry that the increased regulatory scrutiny may place a burden on business.

Downside leverage

One growing structuring trend seen recently, especially last week, was the growth of buffered notes that use a negative leverage factor once the decline of the underlying price exceeds the buffer amount.

Out of the top 10 deals that priced last week, seven used that feature, including the three largest offerings, according to Prospect News data.

Goldman Sachs Group, Inc. priced $13.96 million of 0% leveraged buffered index-linked notes due July 8, 2014 linked to the S&P 500 index. It was the No. 1 product in size.

The notes feature a three times leverage factor on the upside up to a 27% cap. On the downside, investors will receive par if the index falls by up to 10% and will lose 1.1111% for every 1% that the index declines beyond the 10% buffer.

The No. 2 product of the week, which has a 1.25% buffer rate, was brought to market by Deutsche Bank AG, London Branch. This agent priced $8.12 million of autocallable securities due July 9, 2015 linked to the United States Oil Fund, LP.

The buffer is 20%. The notes pay an 11.5% annualized call premium if the fund closes at or above its initial price on any quarterly call date beginning July 10, 2013.

Finally, Goldman Sachs priced the third-largest deal with its $7.73 million digital notes linked to the S&P 500. If the index return is greater than or equal to negative 15%, the payout at maturity will be par plus 7.5%. Otherwise, investors will lose 1.1765% for every 1% that the index declines beyond 15%.

"I can see why people are doing those ratio buffers again," the sellsider said, who noted that some issuers used to offer those structures but then shied away from them.

"You can improve the terms, especially the upside. Current rates are very low, and interest rates are the key ingredient in structuring, so it makes sense that people would try to find ways to make the deals more attractive."

For the market participant, the renewed interest in these structures may emanate from the investors themselves.

"The structure itself has become more widely accepted in the market," he said. "Many of those products are more appealing than a direct investment. More agents are using them in their distribution channel."

Agents that used the downside leverage feature last week included Goldman Sachs, Deutsche Bank and JPMorgan.

"I also think there's a demand factor," the market participant continued.

"People realize that a barrier continuously monitored with only 10% is likely to be knocked out. It's like ... you have no protection at all.

"People understand that you're better off with a 10% buffer and 1.11% negative leverage than a 90% barrier. If your index falls by 11%, the barrier will make you lose 11%, but you'll only lose 1.11% with the negative leverage.

"People in the U.S. are just beginning to understand the benefits of this feature.

"In Europe, investors understand it too. They figured out that in 2008-2009, over 50% of the structures were knocked out. They still use barriers a lot, but their barriers tend to be much deeper."

The structurer agreed that the rise of buffered notes with negative leverage was the result of investors' better understanding of their options.

"If you get a 10% buffer with no leverage, the most you can lose, if I may say, is 90%. When you have a 10% buffer with a 1.11% negative rate after the buffer, you can eventually lose 100%.

"So what's the big deal between losing 100% and 90%? An extra 10% doesn't hurt that much at that point. But in exchange, you can get more upside whether it's done through a higher cap or more leverage," the structurer said.

Partial protection

Another structure trend visible for the year was the strong bid for leveraged products with partial protection, which could be offered either via a buffer or a barrier, the market participant said.

"We're seeing more and more of these compared to full protection products. It's an important trend," he said.

"The structures with full protection don't look at all appealing, and the market realizes the value of a different risk payout. You can change the risk profile of your investment."

Leveraged return notes with partial protection have grown by 14% year to date to $3.74 billion. In contrast, leveraged products that lack any downside protection mechanism have seen their volume fall by 31%, according to data compiled by Prospect News.

The top agent last week was Goldman Sachs with seven deals totaling $35 million, or 36.2% of the total. It was followed by JPMorgan and UBS.

"Having the Fourth of July in the middle of the week really didn't help." - A sellsider

"People in the U.S. are just beginning to understand the benefits of this feature." - A market participant on downside leverage

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