Reverse convertibles, single-stock notes in vogue again; trend driven by volatility spike

By Emma Trincal

New York, June 6 - The surge in volatility seen during last week's sell-off drove a wave of reverse convertible issuance, sources said.

Out of the $547 million priced in 156 deals last week, a big chunk of the sales and the top deals fell into the reverse convertible category. Agents sold $172 million of reverse convertibles in 96 deals, nearly one-third of the total and almost three times the $63 million that priced during the week before, according to data compiled by Prospect News.

Volatility up

The CBOE Volatility index, or VIX index, which measures implied volatility on S&P options, soared by 23% last week to 26.66 from 21.76. Simultaneously, the S&P 500 fell 3% as the market finished the week giving back all of its gains since the beginning of the year in reaction to disappointing U.S. job data on Friday and continued negative headlines about Europe.

The pickup in reverse convertibles was notable in the context of a lackluster four-day week in U.S. structured products issuance following Memorial Day, which saw volume fall by 60% from $1.39 billion the week before. To be sure, the preceding week was very active as most deals closed in anticipation of the long holiday weekend.

The $231 million volume of single stock-linked products, 42% of the total, almost equaled equity index products, which amounted to $242 million and 44% of the market last week, according to the data. So far and in general, equity index-linked notes tend to surpass in number the volume of stock deals, but not last week.

"That rising levels of volatility pushed up the volume of reverse convertibles doesn't shock me because it certainly helps pricing," a sellsider said.

The higher the implied volatility of the underlying stock, the better the terms of the structure, which consists of shorting options to obtain both the coupon and the downside barrier, sources said.

"If you have an opportunity to launch these at a coupon that comes in at a higher rate, you'll sell more that week, no question about it," the sellsider said.

Apple

UBS AG, London Branch issued the two top reverse convertible deals, which were the fifth and sixth largest issues of the week. Both referenced the stock price of Apple Inc.

UBS priced $17.59 million of 10.75% annualized single observation Equity LinKed Securities due Dec. 5, 2012 linked to Apple shares.

The barrier was set at 80% of the initial price. Morgan Stanley Smith Barney LLC handled distribution.

UBS also sold a callable reverse convertible with its $16.65 million of trigger phoenix autocallable optimization securities due May 31, 2013 linked to Apple. The deal featured a 70% trigger price, quarterly observation dates and a contingent coupon at 13.8% per year.

"Apple is the most-loved stock among all the stocks they trade. People like the story. It's easier to be bullish on Apple than on any other stock, and it's an easy sale. Besides, it's also well correlated to the broad market," a structurer said, commenting on the success of this underlier.

Other popular underlying stocks used in reverse convertibles were Amazon.com, Inc., which was used by Morgan Stanley in a $13.4 million issue of contingent income autocallable securities, and JPMorgan Chase & Co., which was used as the reference asset in five deals totaling $17 million and sold by UBS, RBC and Barclays.

"With interest rates so low, people want to generate income. Reverse convertible are one way to get income. The idea of selling a call to generate income is popular," the sellsider said.

"I've also seen baskets of stocks as the underlying and people writing a call on each individual stock. That's a way to do that too," he said.

The renewed interest in reverse convertibles seen last week marks a break from the declining trend observed over the past few months.

The volume of reverse convertible sales dropped by nearly 17% year to date to $2.91 billion from $3.49 billion during the same time last year.

For the structurer, the main driver for last week's pickup was market demand rather than pricing conditions.

"People see the lower prices, they see good entry points. They pick a stock that they like and go for it," he said.

Another big one

But the biggest deal last week was neither a reverse convertible nor even a leveraged play. Instead, it was a delta one product offering access to a global equity index.

Deutsche Bank AG, London Branch priced $55.77 million of 0% notes due June 19, 2013 linked to the MSCI Daily Total Return Net World USD index. The deal caught the eyes of market participants because it was a repeat of a $171.82 million offering that HSBC USA Inc. priced on May 25. Deutsche Bank followed suit last week. Both products are distributed by JPMorgan.

The notes pay at maturity par plus the index return with full exposures to losses.

The daily total return index reinvests the dividends in the index. The index itself seeks to replicate the performance of large- and mid-cap stocks from developed equity markets.

"There are folks out there looking for dividend-paying stocks. Certainly this one falls into the dividend theme that we've seen in this market," the sellsider said.

"When you're unhappy with the yield you're getting in fixed income, what do you do?

"You can go for a high-yield issuer with a low-quality rating, and when interest rates go up your bond will go down in price.

"Or you can look for ways that are less interest-rate sensitive like investing in high-dividend stocks directly or indirectly."

One similar deal preceded the HSBC and Deutsche Bank offerings earlier this year. But unlike those two, it was not sold by JPMorgan. Goldman Sachs Group, Inc. priced $75 million of equity index-linked notes due April 10, 2013 tied to the same index on March 27.

Because all three notes are longer than one year in maturity and because they are merely trackers of an underlying index already available in an exchange-traded fund, sources have speculated that one of the purposes behind the product is tax efficiency. The idea would be to substitute long-term capital gain tax treatment with the notes for the income tax due for the ETF dividends, those sources said.

But the structurer said that despite their big size, the notes may have just been offered to a limited number of high-net-worth clients of JPMorgan.

"I think it's related to asset allocation. You could have one guy moving cash in and out of bonds into equities or from U.S. equities to global equities, and they're buying it in different tranches with different counterparties to diversify the credit," the structurer said.

"Or it's just a case of investors piggybacking on the same idea."

Also last week, Eaton Vance Distributors, Inc. underwrote another series of units. eUNITS 2 Year U.S. Market Participation Trust II: Upside to Cap / Buffered Downside priced $20.4 million of the units.

The trust will end its investment activities on May 21, 2014.

The payout at maturity will be any index gain, up to a maximum return of 20.5%.

If the index falls by up to 15%, the trust seeks to return the initial net asset value of the units.

If the index falls by more than 15%, the trust seeks to outperform the index price change by 15% of the initial index value.

The top underwriter last week was JPMorgan with 17 deals totaling $103.77 million, or 19% of the total. It was followed by UBS and Citigroup.

"That rising levels of volatility pushed up the volume of reverse convertibles doesn't shock me because it certainly helps pricing." - A sellsider

"Apple is the most-loved stock among all the stocks they trade. People like the story" - A structurer

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