Investors say no to caps as markets continue to hit new highs, sources say

By Emma Trincal

New York, June 5 – With the bull market in its sixth year, investors in structured products are increasingly worried about underperformance, leading some advisers to ask issuers to eliminate caps even if it means having longer maturities, less protection or little or no leverage.

A market participant said that caps may become more and more obsolete.

“The story of the cap that was popular for a long time, I personally think that it’s dead,” he said.

“If you look at the types of structures that have done well in the past, they generally used to be shorter-dated products with caps on the upside.

“But in the light of the large run-up we’ve had over the past few years, with the S&P up 32% last year, it’s easy to see that this whole class of products today may not be as attractive as it used to be. People still look at what happened last year, and if you think the market can still go up substantially, a cap of 15% may not be enough.”

A new trade-off

One of the most popular ways issuers have recently removed caps has been through longer maturities, he said.

“The longer-dated structures can give you some protection while being uncapped. You can get a no-cap deal on a five-year with a 20% downside protection. In the four- to five-year terms, you can get very attractive notes without a cap on the upside and with a buffer or a barrier. On some deals, you can get a 20% buffer and up to 40% to 50% barriers. That’s where the value is.

“For advisers, it’s an important message to convey. The cap has become a negative part of the conversation.”

Last month, Morgan Stanley priced $26.91 million of 0% trigger jump securities due May 21, 2020 linked to the S&P 500 index, according to an FWP filing with the Securities and Exchange Commission. If the index return is positive, the payout will be par plus the greater of a 35% digital payment and the index return. Investors enjoy a contingent protection on the first 40% of losses.

“This is just one example that reflects the story around investors refusing caps,” this market participant said.

“If the market goes up, you’ll get at least a digital and perhaps more. Issuers understand that buyers are less and less willing to miss the upside of a bull market. These are the types of structures that work right now: no cap, a long-only exposure with some leverage if possible and, if feasible, some additional bells and whistles. More and more investors prefer having less downside protection in exchange for full upside participation.”

Joe Halpern, chief executive of Exceed Investments, sees the same trend not only with structured notes but also with certificates of deposit.

“The equity-linked CD market saw an expanding of duration a couple years back as volatility and interest rates came in. Essentially, there are just some characteristics that optically look better to a consumer, and in the current market, it is simply necessary to lengthen the maturity in order to achieve these characteristics,” he said.

Less leverage

In addition to longer-dated maturities, issuers are using a variety of techniques to produce the “no-cap” investment a growing number of investors are now looking for.

In some products, issuers combine a longer term with limited upside leverage and a barrier.

Last week for instance, Goldman Sachs Group, Inc. priced $868,000 of 0% leveraged trigger notes due March 2, 2018 linked to the S&P 500. If the final index level is greater than or equal to the final barrier level, 75% of the initial level, the payout at maturity will be par plus 1.25 times the index return, subject to a minimum payout of par.

Fat dividends

Another way to achieve the “no-cap” result without sacrificing leverage or cutting too much protection has been the use of indexes that pay high dividends such as the Euro Stoxx 50 index, which pays a 2.70% dividend yield versus the S&P 500 index’s 1.85% yield.

Last month for instance, HSBC USA Inc. priced $1.75 million of 0% leveraged buffered uncapped market participation securities due May 29, 2018 linked to the Euro Stoxx 50. The upside leverage factor is 1.55, and the downside protection is a 10% buffer. A six-month shorter version of the same product was HSBC’s $4.13 million of 0% barrier leveraged tracker notes offering a 75% barrier instead of a buffer.

Combinations

Some issuers have been able to monetize the use of a high-dividend index to offer shorter-dated products, but in those cases, investors often have to contend with one-to-one upside exposure. As an example, JPMorgan Chase & Co. last month priced $1.16 million of 0% contingent buffered equity notes due Nov. 25, 2015 linked to the Euro Stoxx 50. Investors receive par plus the index return if the index return is positive. They are protected up to a 17.3% loss and exposed to the index decline from the initial level if the index declines further.

When combining longer tenors with higher-dividend indexes, issuers may combine the uncapped upside with some attractive protection levels, such as a 15% buffer. That buffer amount was recently offered by HSBC in a deal based on the Euro Stoxx 50. The term is three and a half years. There is no leverage on the upside.

Good old days

Still, today’s buffers pale in comparison to what the market offered years ago, said Steven Foldes, president and chief executive of Foldes Financial Management LLC.

“In the old days in the structured notes world, when the market was hugely volatile – hopefully, we won’t see anything like that anytime soon again – a 20% buffer was commonplace with two or three times leverage for terms between 13 months and 24 months. Forget anything less than two times leverage! You never had to go beyond 24 months. There were plenty of 14, 18 months available. Significant downside protections were available. The caps were very high. Obviously, these were the old days,” Foldes said.

The funding issues being “what they are” today, the terms today are “much less” attractive, he noted.

“You could get exposure to the S&P, the Russell, emerging markets, real estate with fantastic terms. These were the good old days. But these terms are over. We can get better terms with slightly longer duration, but nothing comparable to what we used to get.”

Adding volatility

For Foldes, finding uncapped notes with downside protection is a challenge, especially if he wants to keep his rule of not investing in structured notes longer than three years.

“It’s hard to remove the cap, stay short-term and still get some decent downside protection,” he said.

“Our durations are kept as short as possible, which obviously limits the options.

“We used to do deals around one year. Then we stretched it to two years. Finally, we’ve gone as far as three years. We don’t really want to go longer than that.

“Can you get the no-cap and the protection? Is it doable? The honest answer is it depends on the structure. We have to drill down what the banks have to offer.”

The range of possibilities also expands with more volatile asset classes, he said.

Foldes mentioned that he would consider riskier assets if the structure were attractive and if it correctly expressed his view on the underlying asset class.

“One of the best deals we’ve made was based on oil. We bought it last year. It was a one-year note with a minimum return and unlimited upside. The barrier was very decent,” he said.

He was referring to Barclays Bank plc’s 0% market plus notes due Sept. 3, 2014 linked to WTI crude oil, which priced on Aug. 16. If the price of WTI crude finished at or above an 80% barrier level, the payout at maturity would be par plus the greater of any gain and the 9.51% contingent minimum return. Otherwise, investors would be fully exposed to any losses.

JPMorgan was the agent.

“We already had oil exposure. But we wanted to add more because of the potential disruption of oil and what happens in the Middle East,” he said.

“Since we don’t go three years or more, it’s a function of the asset class. It depends on what they can generate on the asset sale, on the option price. Every structure is different.

“For the S&P 500 for instance, we haven’t been able to find a no-cap structure with downside protection even on a four year.”

Downside gearing

For those hard-to-find plain-vanilla S&P 500 products, Foldes said that he has been considering longer maturities as long as the structure meets all his other requirements. In some cases, a good buffer can only be secured with some downside gearing. If the payout and risk versus reward make sense, Foldes said he is not opposed to a buffer that accelerates the losses beyond the threshold.

“In fact, one of the notes I liked the most was a Deutsche Bank deal on the S&P I just saw last month. It had a five-year maturity and a geared buffer, but you had the leverage, the no-cap and a hard buffer. So even though we’re not crazy about the five-year [tenor], we liked it,” he said.

He was referring to Deutsche Bank AG, London Branch’s $2.77 million of 0% airbag performance securities due May 31, 2019 linked to the S&P 500. The upside participation rate is 125.9%. There is a 25% buffer on the downside. If the index falls by more than 25%, investors will lose 1.3333% for every 1% decline in the index beyond the 25% threshold. UBS Financial Services Inc. was the agent.

Facing the client

Investors who push their broker or adviser to eliminate the upside cap are not necessarily aggressively bullish. Most of the time, the issue for advisers is to reduce the upside risk as clients have little tolerance for underperformance in a bull market.

“Who knows when the rally will end and why? Markets fool us all the time,” Foldes said.

“If someone sitting at a table with me in December 2012 had told me that we would have a 32% rally in the next year, I would never have believed him given the sequester and the weakness of the economy.

“And guess what? We had a very strong bull market last year.

“Markets go up for different reasons.

“All I know is that in 1995, 1996, 1997, 1998 and 1999, on each of these five years, the market was always up more than 20%, and on two out of these five years, it was up more than 30%.

“We just don’t know.

“Some people want protection, others, more upside.

“Everything is a trade-off. We’ve had notes with very low or even no downside protection because we liked the returns. Maybe others want less upside and more protection. The good thing with structured notes is that there is flexibility.

“The issuers are cooks in the kitchen. They’re adding flavor to what the diners want to taste.”

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