Volatility decline believed to be behind extended tenors, sources say

By Emma Trincal

New York, Jan. 25 - With volatility on the decline, market participants said they are seeing the pricing of more and more deals with long-dated maturities.

"I see longer maturities since the end of last year, beginning of this year," said Thomas Livingston, director of structured products at Halliday Financial Group.

"It starts to get to a point where it's really visible. Your typical CD maturity used to be five years. Now it's seven."

Livingston said that the trend was the most evident with principal-protected products.

"But you see a lot of the steepeners getting longer as well," he said.

Volatility-related trend

So far this year and excluding the pricing of multi-billion-dollar exchange-traded notes, agents have sold 34 deals with a maturity in excess of seven years, which represents a total of $614 million, or 11% of the year-to-date issuance, according to data compiled by Prospect News.

During the same time last year, agents priced the same number of deals for the same tenor, but the total for those long-dated notes was only $289 million, or 6.5% of the issuance volume.

Sources said that the trend is recent.

"Volatility is down a lot. Issuers look for ways to get better pricing," said Livingston.

"They do longer maturities or the worst-of deal that gives them better pricing."

He gave the example of a deal he did last month.

"It was a two-and-a-half-year note with a 30% downside protection and leverage on the upside. It was callable at 110 within a year, so that's great. People didn't mind to be called. Now, you can't even do those deals."

Option cost

Philip Davis, hedge fund manager at Capital Ideas, also attributed the longer maturities to the declining volatility as measured by the CBOE Volatility index, or VIX.

Since its peak last year in May, the VIX has dropped 37% to 17.59.

"VIX is very low. In order to have a decent price on the options, issuers have to go longer," Davis said.

"The issuer takes your money and plays with it. The longer they keep your money, the cheaper it is for them to hedge.

"On the other hand, for the investor, being locked in long term can be very dangerous, especially in an inflation environment."

Volatility and duration

Davis explained why issuers have an incentive to structure their notes with a longer duration when volatility declines. He took the example of a principal-protected product.

"In a principal-protected structure, the issuer buys a call for the cap and buys a put for the protection," he said.

"In a declining VIX environment, the cost of the put is lower and the cost of the call is lower. So generally speaking, it's just cheaper to buy the options and hedge the position."

Davis picked the example of the SPDR S&P 500 exchange-traded fund options, with the ticker symbol "SPY."

"The shares trade at $128.75. The 140 SPY call [with a December 2013 expiration date] costs $10.75. That would cover the issuer if the shares went up more than $140," he said.

A 140 SPY call is a call on the SPDR S&P 500 ETF with a $140 strike price. The owner of the call makes money if the shares go up above the strike price.

"To be really covered, they should buy the 130 SPY call at $15," he said, based on the current share price.

The premium cost divided by the cost of one share gives a total cost of insuring the position of 4% a year over a three-year period, he explained.

"Can you make more than 4% when you're a bank? I would hope so. The longer the duration, the more profit they can make," he said.

On the other hand, when the VIX increases, the cost of hedging is higher for the issuer.

"In a more volatile environment, banks will be less likely to offer principal-protected structures because the cost of hedging will go up," he said.

"But when the VIX is low, it cost them less to increase your upside. They're happy to do it. Remember, the bank makes money by compounding your money."

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