November shows weakness with volume down by a third, but sources say month is not over yet

By Emma Trincal

New York, Nov. 19 – Agents in the second week of the month sold $344 million in 87 structured products deals, according to data compiled by Prospect News, a not-so-high volume compared to the other 45 weeks of the year.

The monthly issuance through Nov. 14 was down 33.5% from the same period in October. Volume from a year ago has declined by 25% in the first half of November, the data showed.

Yet, sources said that it was still too soon to tell what November will be like.

Most of last month’s strength originated from the month’s final week.

During the first half of October, volume lagged the comparable period in 2013 by 9.5%. But for the second half, volume rose by 33% to $2.89 billion from Oct. 15-31 of last year.

November so far

“Volume has remained steady for us. We had a dip in October and everything is correlated. Most markets plunged but we’re back up again. We’re seeing a lot of single-stock based stuff. It’s the result of the low volatility. People are chasing higher premiums,” a market participant said.

He noted that the decrease in volatility seen since the market recovered from last month’s sell-off is not helping pricing. But he put the volatility factor into perspective.

On Oct. 15 when the S&P 500 index corrected, the VIX index hit the 30 threshold. It has now dropped below 15 with the benchmark surging to new highs.

“The rally along with the low volatility levels that we have, make pricing more challenging,” this market participant said.

“When volatility drops, you get lower headline coupons.”

To compensate for the loss of income, some buyers are seeking notes based on single stocks, because individual names have higher volatilities than market indexes.

“But volatility is not the only factor that drives structured notes pricing,” he added. “Interest rates play a very big part too. If interest rates were higher and volatility still low, you could have a very good pricing environment for principal-protection notes.

“What the low volatility does is to make the headline terms less appealing since you get less premium from selling the puts. It’s really for investors to decide whether it’s better than owning the stock outright.

“People get hung up on volatility. But a combination of low volatility and higher interest rates would make a variety of other structures look much better.

“So I don’t think it makes that much sense to say – low volatility is bad for structured notes. It depends on what type of structure you’re using and what the investors are looking for,” he said.

October correction

Still, some see the robust flow of last month as a result of the correction.

Agents priced $3.76 billion in October versus $3.14 billion in the same month last year, a nearly 20% increase.

October this year was the third best month of 2014 so far, after January and July, and in all three months stock prices were under pressure.

“Last month was a very busy month – we had volatility entering in this market, which we hadn’t seen for a while,” the sellsider said.

“When you’re doing structured notes, you’re managing risk. When clients feel comfortable, they want the upside, they look for the outperformance with no buffer, no barrier and they use leverage,” he said.

But when they turn more skittish, the barrier trade, the buffer trade start to come back.

“The October correction was significant enough to cause investors to wonder if they should put all their cards on the table. The idea of looking at structured notes for some downside protection made sense,” he said.

Valuation was another factor.

“When you see the S&P drop to 1900, 1950, clients thought, ‘Maybe I should lock in at a lower level.’ The index has now recovered back today at 2045. At the time, the drop was seen as a buy signal. For some people, locking in the trade at a lower level plus having some downside protection was a good incentive to buy notes,” he said.

In the absence of any significant market move, November’s notional could be weaker, he predicted.

“Let’s be honest. The S&P 500 has plateaued. If you look at the chart since the beginning of November, the benchmark has been trading in a narrow range, somewhere between 2010 and 2050. It’s been almost flat. Investors right now are unsure. They wonder whether we’re at a point where the market is going to break through or whether we’re going to see sellers coming in, leading to another correction.

Buyer’s fatigue may also dampen the action this month.

“Investors were very active in October. They invested heavily. They may be thinking: we’ve put a lot of money in the market. Let’s see how it goes from here,” he said.

“That said, the month is not over yet. Will November be a strong month or not? It’s probably too soon to tell,” he said.

Reverse convertibles

Income plays on stocks prevailed last week, according to the data.

Looking for higher premiums, investors put 50% of the total volume in single-stock-linked notes or $169 million.

Reverse convertibles in various shapes were in favor, accounting for 42% of the total volume, according to the data.

For the year to date, single-stocks amounted to a 28% market share average. Reverse convertible represented 23% of the total.

The top deal was a “step-income” structure, one of Merrill Lynch’s favorite plays and a special type of reverse convertible without a barrier.

HSBC USA Inc. priced $39.75 million of 10% STEP Income Securities due Nov. 27, 2015 tied to Gilead Sciences, Inc. stock. If the stock finished at or above the step level of 110% of the initial price, the payout at maturity would be par plus 5.42%. If the stock finished at or above the initial share price but below the step level, the payout would be par. Investors would lose 1% for every 1% decline in the stock.

Merrill Lynch & Co. was the underwriter.

RBC pair

The next two deals were the old version of the reverse convertible allowing some small participation on the upside.

Both were brought to market by the same issuer. They offered identical terms except for the underlying stock and the coupon amount.

In the first one, Royal Bank of Canada priced $30.74 million of 12.66% mandatorily exchangeable notes due Feb. 4, 2015 linked to International Paper shares. Interest was payable at Jan. 5, 2015 and at maturity.

The payout at maturity was the return of the stock capped at 5%. There was no downside protection.

Similarly, RBC priced $30.57 million of 8.82% mandatorily exchangeable notes due Feb. 4, 2015 linked to Eaton Corp plc shares. The payout and risk exposure were identical to the other deal.

“Clients are looking for a certain type of yield. They’re foregoing the protection on the downside. They’re going shorter-dated. For the risk they’re taking, they want to be compensated. They’re taking a premium plus a little bit of participation,” the sellsider said.

The sellsider said it’s not uncommon for an issuer to break up a deal into two pieces for the same client. None of the deals carried a fee, which seemed to indicate that the client was not a retail client, he said.

“Clearly, it was designed for one client, probably an institutional client. It looks like a replacement strategy for someone who wants a long exposure to the stock,” he said.

The following two offerings also appeared to have been created for the same client but this time credit diversification was the rationale behind splitting the trade into a pair.

Credit diversification

Both offerings also had very similar terms, in particular, the same underlying basket components and weightings, the same maturity date and the same full downside exposure. But the issuers were distinct.

Credit Suisse AG, London Branch priced $30,069,000 of 0% leveraged notes due Nov. 17, 2016 linked to a basket of indexes. The basket consisted of the Euro Stoxx 50 index with a 37% weight, the FTSE 100 index with a 23% weight, the Topix index with a 23% weight, the Swiss Market index with a 9% weight and the S&P/ASX 200 index with an 8% weight. If the basket return was positive, the payout at maturity would be par plus 141.5% of the basket return.

The second deal was issued by Deutsche Bank AG, London Branch for $23.43 million. The structure offered a slightly lower leverage factor or 1.38.

“Again, this is more than likely for the same client who wants to spread out the credit risk,” the sellsider said.

“They’re funding differently so the terms are not exactly the same. The basket is the same though, the duration is identical but we have a tiny bit of less leverage on the smaller deal. But the 1.38 rate offered by Deutsche was close enough for the client to be able to allocate the smaller piece. That’s for a client who doesn’t want to invest close to $60 million with the same issuer.”

Range accrual

The next deal, one distributed by Morgan Stanley & Co. LLC, was a callable range accrual note with some equity exposure.

Credit Suisse AG, Nassau Branch priced $20 million of six-month Libor and S&P 500 index range accrual notes due Nov. 19, 2029. Interest will accrue at 6% per year multiplied by the proportion of days on which six-month Libor is between 0% and 5% and the closing index level is greater than the reference level, 75% of the initial level. Interest will be paid quarterly. The principal amount is 100% protected. The notes are callable after one year.

The top agent last week was RBC Capital Markets Corp. with $69 million in six deals, or 19.91% of the total.

It was followed by Merrill Lynch and Credit Suisse.

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