Outlook 2013: Sellsiders reflecting on the past year seek answers

By Emma Trincal

New York, Dec. 31 - The past year has been challenging, sellsiders said, with structured products issuance volume lower due to tough market conditions and a challenging geopolitical environment in the midst of an election year in the United States.

Last year's sales of registered structured notes excluding ETNs were disappointing, with $33.88 billion for the year versus $41.33 billion in 2011, an 18% decline, according to data compiled by Prospect News.

As a new year begins, market participants reflected on some of the main issues that have hampered volume such as funding spreads or investors' sentiment. What lies ahead will largely depend on how these themes will unfold. A source of optimism despite the erratic market and unpredictable world events was the sense that the industry has tools at its disposal to ramp up distribution and sales, mainly through education and innovation.

Uncertainty

"In 2012 the market experienced several factors that held back issuance and demand for investment products," said Bernd Henseler, vice-president, structured products at S&P Dow Jones Indices.

"One of the reasons was the low interest rate environment and tighter credit spreads that impeded the attractiveness of principal protected issuances. General market uncertainty was another factor leading to subdued demand."

The beginning of the year did not look bad though, sources said.

"We had a pretty nice uptick in the first half of 2012," said John Tessar, senior vice-president, head of structured products at JVB Financial Holdings.

He added that his firm's notional was up almost 400% at the time, attributing partially the "explosive" growth to his firm's relationships with issuers.

"If we look back, the year was a tale of two halves," said Ray Doherty, director, cross asset solutions & strategies at Bank of America.

"In the beginning of 2012, underlying market conditions created very attractive structures in terms of risk and rewards.

"In the second half, the overall volume dropped, which is not unusual in the later part of most years. I believe most of the drop was related to interest rates and commodities."

The lower volume in step-ups, range accruals, CPI-linked notes, and other structured note trades was, in his view, one of the most critical factors behind the decline.

Commodities issuance dropped significantly as well, he noted, probably because investors lacked the conviction to make any directional bet on this asset class rather than for lack of confidence in the product as an efficient way to access it.

Commodities issuance was down by nearly 40% last year, according to Prospect News.

Investors' sentiment

Uncertainty was the main market theme for equity and structured notes alike.

"Structured note appetite depends to a large degree on market sentiment. If people are comfortable investing in the market, they're going to be comfortable investing in structured products," said Serge Troyanovsky, managing director, head of retail distribution North America at BNP Paribas's Structured Solutions Group.

"If the market performs well, the payouts on the majority of products will be attractive.

"The market sentiment to me is a big driver."

One of the most puzzling aspects of the past year's market was the combination of investors' anxiety, uncertainty and no sustained volatility hike.

"In 2012, the market was up 12%. These are the numbers. At the same time, we've seen a continued upheaval in Europe, very contested elections in the U.S. and the approaching potential fiscal cliff, all factors that have made the market outlook uncertain. The market was up but the market sentiment was not upbeat. And yet, the numbers don't lie. Clearly, the market sentiment didn't match up with the market performance."

But Troyanovsky said he was optimistic.

"I think it's going to be a positive for next year as uncertainty lessens.

"Most of the fiscal issues are going to be addressed one way or the other. The European uncertainty is much less acute than it was a year ago. When investors close up their books in December, when they realize that the market was up in 2012, a lot of the uncertainty may have already been resolved.

"All of this creates a positive environment for 2013."

Election year

Tessar agreed that a lot of the uncertainty of 2012 might dissipate in the upcoming year.

In his view, the U.S. presidential election was a drag on volume.

"Anytime you're coming out in the second half of an election year, you wind up with a stale market. The market without question is not as active. If you go back to past election years, you'll see historically that risk aversion increases during these years," Tessar said.

"The level of unpredictability meant that very few investors were willing to take a five-year with some option not knowing how the product is going to be taxed. We've seen less tolerance for risk for anything tied to equity with high optionality and possible risk," he said.

"Despite the growth our firm experienced in the first half, we've definitely seen the slowdown," he said.

After the summer and the election then came the fiscal cliff, he noted.

"The market has been stale as far as movements, volume and velocity. But I'm not pessimistic. Structures tied to equity indexes did well. For the majority of 2012, the S&P 500 was near its five-year highs. Most high-net-worth clients are naturally bullish investors. They have been pretty content with the equity exposure that they had. We've had a slowdown, but I think things will improve this year," he said.

Funding issues

Investors' confidence may build up this year, but the low interest rate policy continues to alter pricing, making it more challenging than ever to offer attractive terms, sources said. While interest rates could rise soon, it would take a non-negligeable increase in interest rates to improve the terms of the products, said Henseler.

Just last month during the FOMC meeting, Fed chairman Ben Bernanke said that interest rates will likely be held low until mid-2015 or until unemployment decreases to below 6.5%. It is at 7.9% currently.

"The main driving force behind the slow issuance that we've seen this past year is a combination of two things: low interest rates and low funding spreads," said Samson Koo, managing director, head of derivative products at Advisors Asset Management.

"Banks are flush with cash. They don't need that much money. As a result, their funding spreads are low."

Funding spreads have a significant impact on the structured products supply even if banks don't rely on structured products for their funding, he said.

"If or when a bank really wants to raise funding through a structured note issuance, you're going to see an improvement in the terms of the products, both for structured notes and market-linked CDs," he said.

Managing expectations

Perhaps investors have kept their expectations too high when it comes to interest rate levels.

In terms of increasing yield, an investor can take on more credit exposure, but in our asset class there's only so much you can do before the risk of the note outweighs the reward, said Doherty.

"Investors need to realize that the underlying components of providing high coupons with moderate risk are not at the same place now as they were at the start of [last] year.

"We all want yield but we have to balance the yield with the risk," said Doherty.

Koo said that he is confident that clients' expectations eventually will change.

"No one gets a five-year 'plain-vanilla' CD at 7% anymore. It's a new world with low yields. Investors still remember the better terms. And it's not always easy to adapt to the reality of today's yields. In the short-term, investors are still adjusting to this low interest rate environment. Over the long-term though, I'm very optimistic about our industry," Koo said.

But some are less optimistic and see investors' efforts to get higher yields getting more frantic.

"With the Fed telegraphing QE infinity, investors have been forced to make a number of changes in their strategies. Lower rates have pushed investors out the maturity curve in an attempt to lock in at least minimal yield. In many cases this works for the issuer and against the investor as locking in low yields for longer makes funding cheaper but does not entice the investor to part with their cash," said Jim Delaney, portfolio manager at Market Strategies Management.

Volatility and volume

Another issue working against structured notes investors this past year has been the low volatility levels, which surprised many given the market uncertainty.

"With the VIX index trading in the mid-teens, there is a sense of relative calm in the markets, which given the situation in the Middle East and Boehner and Obama doing their best imitations of Thelma and Louise, is remarkable unto itself," said Delaney.

"This affects investors in structured notes because lower volatility in the marketplace reduces the value of the optionality contained in a variety of notes issued.

"The conundrum here is that the changes, which would bring back demand for structured products, such as higher outright yields, wider credit spreads and higher volatility, would in most scenarios be more detrimental to the economy as a whole than it would benefit structured note investors," Delaney said.

Koo said that volatility has hurt some products but not all of them.

"Low volatility is blamed for the weak issuance volume seen this year. It's very complex because it depends on the product. You can't generalize. For instance high volatility will help some structures like autocallables, reverse convertibles or buffered notes while it will not be helpful at all for the pricing of most true principal protected products like market-linked CDs or principal-protected notes.

"So it really depends on what segment of the structured products market you have in mind," Koo said.

Tessar said that the coming year may be better, but there is an "if."

"We'll see these improvements only if some of these unpredictable factors become more under control. If the fiscal cliff is truly behind us, if the entitlement issues get to be addressed, if we start putting some bricks into the wall, we'll definitely see some improvement," he said.

Getting the word out

Market conditions can't really be changed. But sources said that the industry should do a better job at organizing itself, especially in getting the message out to advisers and distributors about the advantages of structured products investing.

"The main challenge is education," said Henseler.

"In the U.S., financial advisers play a crucial role because they often act as portfolio managers for their clients," Henseler said. "We're seeing more and more structured products on brokerage platforms, but education still needs to improve and remains the key for growth.

"Both advisers and their clients need to get their arms around those products - the advisers so that they can explain the structure to their clients, and the clients themselves so that they can understand what they want to achieve and what the product is able to deliver."

Another key effort that needs to be made, he said, was to standardize product names and create risk categories in an attempt to make the securities more transparent and more compliant to new regulations, as it has been done in the European structured product space.

"We need issuers to come together and to support a common cause; we should have more industry involvement and participation," said Henseler.

"It comes down again to education. In order to grow as an industry, everybody should speak the same language," he said.

Distribution

Particular segments of the market deserve a more focused attention, some said.

"There needs to be increased outreach to more investor channels," said Doherty.

"There are certain segments of distribution channels, like Registered Investment Advisers and family offices that have not been introduced and educated on structured notes as an asset class.

"Traditionally, these types of investors are looking for protection. They are big users of the ETF product and may need to hedge exposure while maintaining upside.

He said that structured notes may offer hedging and exposure alternatives to other securities, such as options and ETFs.

"One of the purposes of structured note investments is to obtain customized protection. For example, options may only be available for one or two years, and if offered, trade in low volume. In addition, ETFs may be just tracking the index, but are not the actual index. However, by working with a structured note, the product provider could provide principal protection for several years and could also reference the actual exposure the investor is trying to hedge," he said.

Those efforts eventually lead first to build better and smarter distribution capabilities, said Troyanovsky.

Enhancing secondary trading platforms, building up a network of third-party distributors, developing client services are all necessary steps toward growth, he said.

"We place a great importance on how the products are delivered to the end clients and therefore have worked to build up a viability of our platform. Our structured notes offerings were first introduced in 2003, our market linked CD offerings were introduced in 2010 and finally the ETF was launched in 2012. Different delivery vehicles allow a broader array of strategies to be delivered to a greater client base," he said.

"We really need people to better understand how to best implement structured products," he said.

What is more relevant than the details of each product, he said, is to promote the conceptual framework of structured notes and help investors understand their benefits in terms of "new markets, new strategies, new hedging and new opportunities."

If last year was not one of the most robust years, it certainly was not the weakest. For instance, 2009, with $28.48 billion, was far worse, according to the data.

If anything, industry participants said they have learned a few lessons on how to adjust to mediocre market conditions.

"I don't think 2012 was a bad year," said Doherty. "It's not that people were shying away from products. With lower interest rates and tighter credit spreads, we had very specific reasons for a pullback."

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.