Market conditions lead issuers to monetize volatility with calls, contingency, source says

By Emma Trincal

New York, May 9 - Volume for 2012 continued to be sluggish as May began on fears around European elections in France and Greece on Sunday and weaker-than-expected U.S. economic data.

Issuers trying to sell their products are increasingly introducing "conditionality" in their structures as a way to offer "headline coupons" or possible early redemptions, a market participant said.

Some of the "contingency" incorporated into the deals included contingent minimum returns and call features.

Agents have priced $13.18 billion this year through Friday, a nearly 23% decline from the same period last year when the total was $17.05 billion excluding exchange-traded notes, according to data compiled by Prospect News. Meanwhile, the number of offerings has grown more than 35% to 2,953 from 2,178.

Not surprisingly given the monthly cycle, volume last week, which was the first of the month, was down from the week before. Sales dropped 81% to $267 million from $1.4 billion in the month-end week ended April 27. The number of deals declined to 91 from 301, according to data compiled by Prospect News.

There were 35 deals over the $10 million size in the last week of April versus only six last week.

The month-to-date volume declined by 23% to $158 million from $206 million during the same time in April.

Euro clouds again

"Volume is mostly down," a structurer said. "People are either positioned on waiting or they're gradually exiting the market because of the traditional 'sell in May and go away.'

"The market is not very supportive. There aren't that many asset managers jumping in at this time.

"Spanish yields are at 6% again. CDS spreads are rising for some European countries; they're back above the 500 basis points line.

"And last week, we've had the uncertainty around the French vote. Nobody was 100% sure that the Socialists would win the elections on Sunday. Investors were also skittish in anticipation of Sunday's elections in Greece."

The CBOE Volatility index, or VIX, rose by 15% last week but remained under 20, leaving the door open to diverse interpretations regarding the direction of the market, he noted.

"Rising volatility is good for pricing, but you don't see much of an impact on demand because uncertainty prevails over price levels," this structurer said.

Volatility still low

The market participant explained that current levels of volatility help explain the sideways trading accompanied by a slower issuance pace.

"Even though volatility has been rising, it's still at pretty low levels," he said.

Closing at 19 on Friday, the VIX remains well below its 52-week high of 48.

"What complicates issuance of structured products right now is that you need high interest rates and high volatility to provide better returns," he said.

"Issuers are trying to monetize volatility with various structures because interest rates are low and volatility is quite low. It's hard to provide juicy returns."

A look at the favorite structures that priced last week gives an indication of what issuers are trying to do to boost demand, he said.

Call mania

The No. 1 and No. 3 deals were callable reverse convertibles. This type of structure accounted for nearly a third of the total sold, according to data compiled by Prospect News.

Other favored deals included contingent buffered notes such as step-up notes, absolute value products or structures offering a contingent return. All are structured around downside barriers that expose investors to full losses once breached. On the upside, the return is offered under certain conditions, which often dictate that the underlying close above its initial level or price on a set date or above a certain threshold.

Last week, the number of deals with a downside barrier reached 67. In comparison, only 23 offerings provided a hard buffer for the downside protection.

Calls are one of the features issuers are incorporating in their structures as a way to give investors an incentive to buy, the structurer said.

"Everything that can be called is en vogue," he said.

"With a call, the issuer can induce the feeling that the maturity is shorter if the investor's view materializes.

"The issuer can say 'You want a two year? Do it on an autocallable based on a semiannual or quarterly call date.' It might be good if volatility is high; you could get much better terms. And that's certainly a way to make people think they're buying shorter durations."

Top deals

JPMorgan Chase & Co. priced the largest deal of the week, $46.92 million of contingent income autocallable securities due May 2, 2013 linked to General Electric Co. shares. JPMorgan Securities LLC was the underwriter, and Morgan Stanley Smith Barney LLC handled distribution on this offering, a callable reverse convertible.

If GE stock closes at or above 80% of the initial share price on a quarterly determination date, investors will receive a 2.1675% contingent payment. Investors also have the potential of being called at par plus the contingent payment if the stock closes at or above the initial share price on any of the first three quarterly determination dates.

At maturity, any price decline below the 80% threshold will leave the investors with GE shares equal to $10.00 divided by the initial share price or, at the issuer's option, the cash equivalent.

The second big callable reverse convertible note, and the No. 3 deal of the week, was Morgan Stanley's $13.93 million of contingent income autocallable securities due May 5, 2014 linked to the common stock of Apple Inc. The structure is the same but with a 70% downside threshold level and a contingent payment of 3.6875%.

Contingency

Twin-win notes continued to be popular. JPMorgan priced a contingent absolute return autocallable optimization note linked to Genworth Financial, Inc. for a little less than $10 million.

The use of call features, contingent buffers and downside leverage on buffers reflected a common issuance trend, the market participant said.

"It's a way to monetize volatility," he said. "Because rates and volatility are down, you have to add more conditionality. You don't want to compromise the headline coupons.

"With a callable reverse convertible, you add more conditionality. The absolute value structure adds two conditions on both sides of the trade. They give you a positive return both on the upside and on the downside as long as the performance is within a range.

"Contingency is a way to offer more attractive coupons. You could get a more conservative barrier, but a low barrier with a low coupon is not going to be attractive."

Rates, FX

All asset classes declined sharply last week except for rates. With one $25 million deal, Bank of America pushed up the market share of this asset class to 9.5% of the total, but it was the only deal in this category.

Bank of America Corp. priced $25 million of callable capped notes due May 4, 2032 linked to the 30-year and two-year Constant Maturity Swap rates.

The coupon is 11.25% for the first year. After that, it will accrue at four times the difference between the 30-year CMS rate and the two-year CMS rate, up to a maximum rate of 11.25%. The payout at maturity will be par. The notes are callable at par on any quarterly interest payment date after one year.

"Rates are more popular because you have more directional views on rates, while it's hard to know where the market is going with equities," the market participant said.

"People expect rates to go up at some point. There is more consensus," he added.

On a year-to-date basis, deals linked to some asset classes have seen their volume grow, such as equity indexes, up 7.25% at $6.59 billion; exchange-traded funds, which have risen by 24% to $728 million; and FX-linked products, up 36% at $392 million.

Equity indexes remain the most widely used asset class with 50% of the total issued year to date versus 36% last year.

The top currency deal last week was Barclays Bank plc's $11.1 million of 0% notes due May 8, 2014 linked to the performance of the Chinese renminbi relative to the dollar. It offers full principal protection and 1.44 times leverage on the upside. The deal was sold by JPMorgan.

JPMorgan was the top agent last week pricing 10 deals totaling $70 million, or 26.25% of the total. It was followed by UBS and Bank of America Merrill Lynch.

"Issuers are trying to monetize volatility with various structures because interest rates are low and volatility is quite low." - A market participant

"Everything that can be called is en vogue." - A structurer

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