Recent Treasury sell-off may reduce tenors, improve terms of principal-protected notes, CDs

By Emma Trincal

New York, March 15 - Structurers and distributors of market-linked certificates of deposit predict that the durations of fully principal-protected products, both notes and CDs, are likely to get shorter as Treasury prices continue to decline.

"Rates are up. With higher rates, you may see more principal-protection trades because you have more money to work with," a sellsider said.

The benchmark 10-year Treasury closed Thursday with a yield of 2.28%. The Treasury sell-off picked up in momentum last week. On March 6, the yield for the benchmark was 1.94%.

Buoyed by more positive economic news in the United States, investors have flocked to the equity market, pushing the S&P 500 index above the 1,400 mark, and raced to the exits in the Treasury space.

"The revised job data is positive, and the Fed offered a better economic outlook on Tuesday. There is less conviction that QE3 is going to happen," this sellsider said.

"The stress test results have also helped."

No one knows if the recent slump will last. But many see the Treasury market as overbought, leaving room for yields to grow more.

If that is the case, it would be good news for conservative investors who buy only products - notes or structured CDs - that are fully protected.

One of the components of those products is a zero-coupon bond used to repay 100% of the principal at maturity. The other is a call option used to offer the upside participation in the reference index or asset. As interest rates go up, the cost of the package decreases since structurers have more money available to purchase the options.

More room to play

"The recent sell-off in rates should enable structurers to increase participation and options payoff," the sellsider said.

He gave an approximation of the improved economics based on Wednesday's spreads.

"On Feb. 29, the five-year swaps were at 1.11%. Now, it's at 1.34%. That's a 23 basis points increase," he said.

"For the five-year period, you had 5.5% to play with a month ago versus 6.7% now. It's 120 basis points, or 20%, more to work with."

He said that the decreased cost should help volume and reduce the lengths of products.

"If credit spreads were to be coming in a lot, it may offset that. But with [CDs], it's different. Credit spreads don't move on CDs," he said.

"I expect CDs to get shorter in duration: the six years pulling back to five years, the seven years shortened to six years."

The impact of rising rates will be less significant for capital-at-risk structures, he said.

"It's going to be felt mostly on principal-protected notes and CDs," he said.

"Equity products pricing depends much more on volatility and the value you get in selling volatility. Those structures are not rate sensitive like the zeros."

Unbelievable growth

Mike Sherzan, president and chief executive officer of Bankers Financial Services LLC, an underwriter of market-linked CDs for banks and credit unions, said that interest rates may not affect demand but will certainly change the nature of the supply being offered.

"Depending on the type of product, there's no question that a rise in interest rates will affect the structures of those things," he said.

But he said that demand for structured CDs is not interest-rates sensitive

"We've seen it with market-linked CDs and also with equity-index annuities. Demand has exploded even with very low interest rates. It's unbelievable the growth of this industry," he said.

"From a consumer perspective, those structured CDs will continue to grow because the need to participate in the market without taking losses overshadows whatever the levels of interest rates may be or what the Fed is doing."

More features

David Hutcheson, head of operations and trading at CD Funding group, also sees structurers improving terms on the products.

"You'll see shorter products or a wider range of structure types or more structure features if we keep going toward a higher interest rates environment," he said.

"I think the shorter durations will come first because investors need it. There is a mental hurdle when you get past a five-year maturity, especially in the market-linked space. It doesn't fit with the framework. Right now, the very short end of a market-linked CD would be five years."

Some additional and improved features, he said, may include "an increase of the potential upside for some products, like yield-generated products" or "higher minimum returns."

A fixed-income structurer said that he is already working on shorter-dated products for his clients.

"It really makes sense," he said.

He said that he structures 15- to 20-year fixed-rate callable or step-up callable notes.

"Some clients have a coupon target, and over the past few days we've been able to shorten the duration. Instead of an 18-year product, we've offered the same coupon but on a 15-year maturity," he said.

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