Outlook 2012: Upcoming year should see variety of structures aimed at changing market

By Emma Trincal

New York, Dec. 30 - Structures next year are likely to be direct responses to market developments, in particular, to the volatility brought by the advance of the European debt crisis. Sources expect a variety of structures to emerge in an effort to provide diversified tools to investors who need to adapt quickly to a more volatile market.

"We are seeing a number of trends in the markets. On one hand, investors are looking for more familiar underlyings such as U.S. equities, which still represent the largest portion of the structured products market. At the same time, we are seeing increased awareness and interest in other asset classes such as global equities, commodities and foreign exchange," said Serge Troyanovksy, head of retail distribution, North America for structured products at BNP Paribas.

"As far as the structures are concerned, we see three major themes among retail investors: the search for income enhancement; participation in the market upside; and desire for enhanced upside participation."

CD growth

"Yield-driven strategies will continue to attract greater market share," predicted Keith Styrcula, chairman of the Structured Products Association.

The strong bid for certain products impacts distribution. Styrcula said that bank distribution channels could benefit from this search for yield.

"There will be an uptick in retail bank distribution with FDIC-insured market-linked CDs. The personnel in this distribution channel are highly energized and have rapidly grown the market. It's the right product for the right times," said Styrcula.

"We see a continued trend toward rate products and toward FDIC-insured CDs. We predict that CDs will grow by 10% next year," said Sean Gordon, head of third-party distribution, Investor Solutions at Barclays Capital.

"Separately, quantitative strategies, or notes tied to algorithms, should also see a modest increase next year," he added.

Meanwhile, the market environment will continue to be uncertain with the European debt crisis perhaps worsening or, at the very least, adding more volatility in the market. And while no one knows for sure if volatility will soar or decline, its moves will affect the pricing of structured products embedded with options.

"Market conditions and volatility have an effect on supply and demand," said Gordon. "If the client wants principal protection, high volatility is going to hurt pricing. However, if they want principal at risk, high volatility is going to help.

"Retail is more focused on principal protection, accessing different asset classes via FDIC-insured CDs, and we're seeing strong demand for interest rate-linked notes.

"On the other hand, private bank clients and off-shore [Latin-American] investors have a stronger appetite for principal-at-risk products."

Andrew Valentine Pool, main trader at Regatta Research & Money Management, said the structures that can adapt to particular market directions, whether the market goes up or down or trades sideways, will "continue to do well."

Plain vanilla

The strong bid for plain-vanilla products, which was one of the characteristics of 2011, will remain significant in 2012, sources said.

"Retail investors will continue to buy fixed-income, vanilla types of products such as fixed-to-floaters and step ups," Gordon said.

"A lot of these products sold very well in 2011 for a couple of reasons. One was the search for yield. The other was a return to basics. Callables and step-up agencies have been around for quite some time, and the market naturally moved into corporate bonds next. People have now been familiar with these types of structured products for more than a decade."

Liquidity and ETNs

Another continuing trend is the need for more liquidity.

"Pricing will continue to improve, albeit slowly, but the development of a secondary market is way behind. We need the secondary market to grow, grow, grow," Pool said.

Liquidity was one of the "big themes" identified by Gordon as well along with "an increased focus on education," "more product transparency" and "additional product access."

"One way to improve liquidity is via technology. The industry is moving in that direction. A couple of third-party vendors are helping in that regard, working on platforms that could bring liquidity to the next level," said Gordon.

The development of a mature ETN market has been a direct response to the growing need for transparency and liquidity on the part of investors. For that reason, market participants remain cautiously optimistic about the prospects for this market segment.

"Demand and issuance volume for ETNs will be contingent upon credit risk appetite going into the New Year," said Ian Merrill, head of product origination, Americas, Investor Solutions at Barclays Capital.

"The field has gone crowded, and we don't see our platform growing massively next year. But we still think that ETNs are very much an important part of a portfolio."

But ETNs are not just liquidity tools. They also serve very specific investment needs, according to Samson Koo, managing director, head of derivative products at Advisors Asset Management.

"ETNs try to enable advisers' own view, unlike a structured note that is designed to give the investor a certain way to invest in an asset class or security, for instance using leverage. ETNs are more designed as trading tools. That's why they keep on growing," he said.

Rules of the game

The past year marked the first anniversary of Dodd-Frank financial reform, which has already had an impact on the way derivatives are hedged and compliance for investment advisers. Market participants by now are aware that the enhanced regulatory scrutiny is a trend that is here to stay.

"It's safe to say that enhanced regulatory scrutiny will be a challenge every year around this time, but it will be much more at the forefront in 2012. It's developing on the federal, state and global levels," said Styrcula.

Many in the industry have embraced compliance as part of doing business.

"We closely monitor developments in the industry and look to the regulators as well as the internal guidance on the best practices for market participants," said Troyanovksy.

But others question the efficiency of adding new rules.

"We should have learned this from Enron and, more recently, excessive leverage use in 2008," said Pool.

"However, regulation is a tool that is being used to massage corporate culture and client emotions such as greed. Not only is this difficult, but it takes quite a bit of time. Perhaps some would even say it is pointless."

Options abound in 2011

The past year has seen issuers trying to adjust to rapidly changing market conditions, sources said. If investors still had to worry about risks and returns, they at least had options to choose from, according to those sources.

Adaptability

"We are seeing a greater choice of tools available for investors," Troyanovksy said.

"For commodity investors, there are enhanced solutions to access commodities that address pitfalls such as costs associated with rolling futures in a contango environment.

"For investors looking for tail risk hedging, there are new choices in employing volatility as a defensive shield for clients' portfolios."

In 2011, caution was an important theme along with transparency. Often downside protection and simplicity were two features that would attract the same type of investor.

"In times of turbulence, investors tend to favor structures and underlyings that they are familiar and comfortable with. We have seen 'flight to safety' to the more familiar, large-cap U.S. equities as well as broadly based indices such as the S&P 500," said Troyanovksy.

"I can only speak for us, but in terms of structure we are leaning towards our enhanced growth products having at least some buffer versus none at all. Giving up some upside to protect our clients is worth it," Pool said.

CD fever not over

The appetite for market-linked certificates of deposits has been on the rise, according to Troyanovksy.

"We have seen a great interest in products that provide investors with safety of principal and an opportunity to generate yield in excess of what investors could get in plain-vanilla bank CDs," he said.

Gordon agreed and said that he saw investors getting more and more comfortable with market-linked CDs. Among those products, some structures emerged as favorites.

"For mass retail, CDs tend to be the wrapper of choice," he said.

"One particularly popular underlying for CDs has been a basket of stocks, with each stock locally capped, at an autocap level, with a floor applied at the individual stock as well. If the basket is up or flat, you get 10%, for instance. People like those products for the potential income and for the diversification of the stock basket."

Leverage with or without protection on the downside was a must for many investors, as this category of products accounted for a little bit more than a third of the total volume in 2011.

"Leverage is here to stay as a concept. I don't see it losing popularity next year as long as rates remains very low, which they are likely to be," Merrill said.

Complexity

As a sign of the greater maturation of the U.S. retail structured products market, some advisers and investors alike have adopted more complex products in order to pursue very specific investment strategies.

"People are starting to embrace the concept of using algorithms to invest in different markets," Koo said.

"They're getting more comfortable relying on the model in order to pick the right investment in a more efficient way."

Currency blues

Perhaps one missing link in 2011 was the lack of interest on the part of investors in currency-linked notes, something that has some issuers puzzled.

"One area where Wall Street would like to see additional progress is foreign exchange," Gordon said.

"Private banks have had more success here, as their clients look for broad diversification. Mass retail on the other hand is a little less focused on FX as an asset class.

"In the U.S. structured products space, FX products have never been big because investors are used to doing everything in dollars. Also, the equity culture is strong in the U.S., making FX somewhat of a laggard.

"But it's something that Wall Street as a whole can work on changing. It's a matter of modifying the mindset of retail investors. People at some point should realize that by not having FX in their portfolio, something is missing, and that is they don't really have a hedge against all their U.S. assets."

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