Outlook 2015: Bull market or not, structured products volume to grow; industry seen as resilient

By Emma Trincal

New York, Jan. 2 – The year 2014 turned out to be a better year for structured products than most expected. Market participants were relatively optimistic for the upcoming year, even if many expect issuance volume to grow at a slower pace.

While the U.S. structured products market is resilient and can adjust to most markets, the strength of the volume and nature of favorite structures for this New Year will still depend on market conditions, which may or may not resemble 2014.

The strength of the bull market and direction of interest rates will be key in setting the tone perhaps very early on, sources said.

Another big factor will be future developments in distribution and the role of the No. 1 player, BofA Merrill Lynch.

But overall, short of a tail event in the dimension of the 2008 financial crisis, market participants were rather cheerful for the coming year as they see the structured products industry as resilient in most market environments.

Best since 2008

Agents sold $40.53 billion of structured products in 2014, as of Dec. 17, making last year the best after the $50.50 billion record set in 2008, according to data compiled by Prospect News.

Issuance volume was up 11.50% from the previous year as of that day.

“We had a pretty good year, and it’s intriguing. It’s not something I would’ve expected a year ago,” said John Tessar, managing director, structured products at JVB Financial Group, LLC.

Equity neared 90% of total volume, dominating the entire year and reflecting the appeal of the long bull market.

Prospect News data do not include exchange-traded notes, certificates of deposits and plain-vanilla fixed-income notes lightly structured, such as notes tied to Libor.

“2014 was a robust issuance year. Volumes were primarily driven by equity-linked structures that have picked up the slack from other asset classes,” said Jorge Chancay, vice-president in equities and funds, structured markets solutions product origination at Barclays.

Distribution improves

Developments of distribution also contributed to the volume increase.

“The structured investments industry had another terrific year,” said Keith Styrcula, chairman of the Structured Products Association.

“Much of that had to do with distribution and a continued run for a bullish equities market. We saw more assets migrating from managed mutual funds and into index-linked ETFs and structured notes. Mutual funds have been underperforming the S&P benchmark, and many advisors are now looking to S&P-linked structured notes to gain exposure to the equities markets. This phenomenon definitely drove volumes this year.”

The party should still be on this upcoming year.

“We see an increase in issuance volume for 2015,” said Liam O’Neil, managing director, head of the markets group for BofA Merrill Lynch.

“Part of it will be a result of the market. Another part will come from our clients themselves. Success is a matter of commitment, reputation, and client-centeredness.”

A lot indeed will depend on BofA Merrill Lynch. As an agent, the firm contributes to 27% to 30% of the market. It is not uncommon for Merrill Lynch to price more than half of the U.S. market notional during the final week of some months, which is when the firm closes its deals.

More growth ahead

“I don’t have a crystal ball, but I’d say we could see an 8% to 9% volume growth in 2015 in the structured notes space,” Styrcula said.

Tessar predicted a 10% to 15% increase in volume.

“We are well positioned to see some volume growth in 2015. Our projections are positive, not just for BNP but for the structured products space as a whole,” said Raul Perez III, director, head of retail structured solutions at BNP Paribas.

Some of the “bad stories” of last year may become good news.

Commodities are an example.

“I’m taking a slightly defensive posture for this upcoming year. I believe physical commodities will soar. There is likely to be a slight increase in interest rates which, combined with the equity pullback, will benefit the more conservative products in the structured investments toolbox,” said Styrcula.

Commodities were in bear market territory, with the S&P GSCI Commodity index down 30.5% for the year, as of Dec. 17, in great part due to plunging oil prices. The downturn gave retail investors little appetite for the asset class. There were some exceptions however as volatility pick up combined with backwardation for some commodities made for attractively priced offerings. Some larger deals ensued, for instance a $311 million deal brought to market by JPMorgan in November.

The result was a bad story turning better: commodities volume ended up rising by more than 20% for the year.

In equities, with an aging bull market of nearly six years old, most observers were hesitant to make a forecast.

“It’s very hard to predict future volume and structures because so many factors come into play, not just the direction of the equity market, but also the credit of the issuers, interest rates, put/call forwards, which is only one of the inputs in pricing options, said Glenn Lotenberg, managing director, in charge of all structured products distribution for Incapital

The correction scenario

The most daunting question was whether the bull will still be running as it approaches its sixth birthday in March.

Observers were cautious amid recent signs of market turmoil in October and December.

“I have no crystal ball but I agree with the research experts who think the correction is likely to come in the second half of the year,” said Styrcula.

The impact on notes issuance will depend on the severity of the correction if there is one.

“There’s a difference between a correction and a bear market,” said Samson Koo, managing director, head of derivative products at Advisors Asset Management.

“If we have a simple correction, people may find even more reasons to use structured products.”

“A potential downturn in the market presents an opportunity for the issuance of market-defensive structured notes of course,” said Styrcula.

Buffered notes, absolute return deals and principal-protected notes come to mind, he said.

“A correction would probably be a positive for the pricing of reverse convertible and autocallables as investors who sell volatility would likely get at better terms,” said Lotenberg.

“However, this is likely to come with additional risks. There is no free lunch. Education is still necessary even though specific products are either commoditized on haven’t been in vogue for a couple of years.”

Fixed-income alternatives

In a correction scenario, investors could seek the safety of fixed-income and fixed-income alternatives. At the same time, some may look for equity exposure with buffers or contingent protection.

“There are still a huge lot of investors who demand 100% principal protection, which at such cost doesn’t make sense,” said Tessar.

“But investors can turn to buffered notes, which are the gem of our business.

“When you are mitigating risk and enhancing alpha in a single product, you are achieving most of the responsibility that your client asks of you in a single investment.”

A number of structures may emerge from a sell-off, said Styrcula.

“Absolute return, volatility-control indexes, and buy-write strategies may benefit in a market that has a modest downturn,” he said.

The prevalent structures will depend on investors’ risk tolerance.

“If we see a correction, there will be a flight to safety with a strong demand for the safer principle-protected notes,” said Perez.

“Some tactical investors may bet on a market rally after the dip. We may see more short-term, three times leverage deals as people will seek to capitalize on better entry prices.”

Volatility, please

There was a consensus around the idea that too much volatility such as that seen in the last quarter of 2008 can ruin the business but that too little volatility is not helpful either.

Tessar said the market needs to see price moves across asset classes.

“A lack of volatility in both rates and equity would ultimately be negative for this market,” he said.

“We need some movement in rates. I don’t think we can benefit from volatility unless rates move up to 3%.

“The S&P has seen its volatility spike several times during the past year. But it never lasted very long.

“Higher volatility is necessary to build more creative structures and see some increase in volume.

“If volatility and rates remain low, it’s a very bad thing for the market,” he said.

“The timing of volatility was tricky,” said O’Neil, commenting on some volatility increase seen in July and October.

“Volatility spikes happened during such a narrow window, it didn’t help the pricing of the notes very much.

“Having more volatility would certainly help create better buffers and produce shorter-dated notes.”

Volatility is not only good for pricing. It also gives investors an opportunity to review their portfolios, said Perez.

“When there is a sell-off, investors and advisers strive to better manage risk. They consider reducing their long exposure and getting some protection while still participating in the upside. Obviously structured products are an ideal way to accomplish those goals. It’s the right time to look into it,” he said.

A market pullback could also have an impact on the secondary market.

“In the event of a substantial sell-off, some secondary market paper would likely be trading at deep discounts from previously issued trades of a couple of years ago,” said Lotenberg.

“You could see a dislocation between new issues and secondary paper.”

Uncapped trades

Not everyone predicts a correction for the year 2015. Rather the consensus gravitates around a short-lived pullback leading to a flattish market. While the Federal Reserve is expected to raise interest rates in the middle of the year, the well-anticipated change in monetary policy is no longer associated with a market crash.

A weaker bull may incite investors to use leverage more.

“If the market doesn’t go up by more than 5% to 8%, leveraged notes will make a strong push,” said Tessar.

“Structured notes can get you in the game on the upside even if it comes with a cap.”

Short-term bullish structures in particular should continue to be popular.

One of Merrill’s best-selling products – three-time leveraged notes with a respectable cap and no downside protection – could continue to be in demand if the bull market runs out of speed.

“Those notes were popular due to the upside participation,” said O’Neil.

“They met the fundamental bullishness of our clients. They are also short-term products that are very easy to understand. While we still have to explain the structures, many clients are accustomed to these products such that the notes are a consistent part of their portfolio allocation just the same way as ETFs.

“While there is still credit risk, the maturities are short without being tax inefficient.”

Investors who don’t like the full downside exposure can rearrange the trade-off – extending the maturity for a buffer, he said.

Alternatively, they can “dial up or dial down” the risk exposure by choosing position sizes they are comfortable with.

“We think accelerated return notes will continue to be in demand next year,” he said.

Other “bull-friendly” structures will be those offering full upside participation.

Advisers tend to like those products for long-term growth when using structured notes as part of their core portfolio, said Koo.

“They don’t want to underperform the benchmark especially in a bull market,” he said.

Merrill Lynch routinely finds success with its market-linked step ups. Investors get a digital payout in the amount of the “step payment” when the underlying finishes positive or above a barrier but below the step level. Above it, they get one-to-one upside.

“Investors like those products because they are not capped on the upside, which is appealing to our bullish clients. At the same time, the step payment allows you to outperform if the market is flat,” said O’Neil.

A continued rally may also fuel the fear that the market is too “toppy,” making some structures more appealing for the more conservative investors.

“In the event that the full bull market continues unabated, investors may turn more cautious,” said Perez.

“We’re already in this long-dated bull cycle. Are we approaching the end of it or is there more to come?

“These will be questions that investors will be asking.

“People will be more vigilant and they will be watching for signs of this bull converting into a bear.”

Perez predicted that the market would turn “flattish” this upcoming year.

“Most people will look for more range bound, absolute return products, which allow you to score gains regardless of the direction of the market within a certain range,” he said.

No matter what direction stocks go, market participants were confident that volume could continue to grow due to the adaptability of the structures and the variety of options available to structuring desks.

“The great thing about structured products is that you can find what fits your needs at the moment,” said Koo.

“Income deals give investors who want income now what they want. Uncapped leverage notes give bulls the maximum return in the future that they’re looking for.

“This is why we have an industry that has the capacity to grow. We’re able to serve people’s needs in a variety of different ways, regardless of market conditions.”

Beta, commodities

One casualty of a bull market could be the distribution of smart beta index-linked notes.

“Content is hard to sell in a bull market,” Styrcula said.

“Some products tied to more sophisticated proprietary indices had difficulty raising assets because of the performance of the S&P. Notes tied to smart beta indices are a hard sell when the vanilla benchmarks keep hitting record levels.”

But that was for 2014. If the rally stabilizes or reverts, interest in those strategic product, is likely to pick up.

Commodities remain a wildcard, as they suffered from the appreciation of the dollar and the collapse of oil.

But Jodie Gunzberg, global head of commodity at S&P Dow Jones Indices, in a December research note, pointed to good returns in some sectors such as agriculture, precious metals and livestock, according to S&P GSCI sub-indexes.

“Despite the oil price drop, 10 commodities in the S&P GSCI are in backwardation, a sign that commodities ex-oil are turning,” she wrote.

“This was not a good year for commodities, which meant that vols were cheap and some interesting twin-win structures could come to market,” said Styrcula.

“Oil, precious metals got crushed this past year. But current prices don’t reflect the massive purchases of the physical from the governments in China, India and Russia. We could get to an inflection point this year where the demand for physical crushes the paper shorts and a historic spike-up will occur. Some family offices and small institutions have been looking at structured notes that are tied to the physical,” he said.

The biggest surprise

Many complained about the low interest rates levels, but the market expects a change with the Federal Reserve raising rates in the middle of the upcoming year. In its last meeting of the year, the Fed hinted that it would raise rates, perhaps as early as April.

Higher rates would have an impact on structure terms and demand for protection. But the outlook remains uncertain.

“One of the big surprises of 2014 was the direction of interest rates,” said Lotenberg.

“You had short-lived flights to quality when rates spiked. But the trend has been a tremendous bond rally, which very few expected.”

“As long as interest rates will remain low, equity-linked notes will likely see their volumes increase.”

“People have used equity in income products as a way of enhancing yields because we’ve seen a dip in yield this past year,” said Tessar.

They also used these notes as a hedge against interest rate risk.

“It’s one thing to own a six-month autocallable or reverse convertible tied to equity; it’s another thing to be invested in a 20-year bond,” said Tessar.

Higher rates would make the economics on market-linked certificates of deposits and principal-protected notes more appealing.

“I don’t expect a return of full principal-protected products next year,” said Tessar.

“Interest rates would have to go up a lot.

“I don’t know if we can get there yet without a substantial swing on the upside.

“If we go over 3% to 3.50% during the year, we will start to see viable structures even if pushed up to seven-year, in that case, yes, principal-protection could come back into favor.”

On the other hand, if rates go up this year, income-products may lose some of their appeal, predicted Perez.

“But it’s unlikely because rates would have to go up significantly. The Fed has to be very conservative in raising rates in order to avoid putting economic growth at risk,” he said.

“People’s preferences may change however, and you may see less conversation around income and more around long-term growth.”

Interest rate moves also impact the balance between notes and market-linked CDs.

“Right now, non-protected notes are more in favor. But the pendulum could easily swing back to protection and CDs,” he said.

“If we see structured notes issuance drop significantly, it will be trending the opposite way. You’ll see an increase in principle-protection and CD products.

“I predict this is the upcoming trend. I’m not sure it will happen in 2015, it may take a little bit more time, but we’re getting there.”

Deals whose value relies on algorithms or strategies could be in demand this year as they tend to fare well in almost all market conditions, sources said.

“One trend we see for this upcoming year, which has been our approach for a while now, is content,” said Perez.

“People want access. I am not merely talking about access to some asset classes or world markets but rather to strategies, alpha, actively managed portfolio or smart beta indexes. In other words, they want content, not just good terms.”

Examples of such deals include JPMorgan notes tied to the JPMorgan exchange-traded fund Efficiente 5 index; BNP’s market-linked CDs tied to the sector rotation methodology of Dorsey, Write & Associates, LLC. Other notes issued by Scotia and Bank of Montreal gave investors access to Raymond James’ equity research.

The agnostic trend

With more products using those unconventional underliers, notes may no longer be the only way to deliver structured payouts.

“Once you have a viable strategy, you can use it under different wrappers. That’s another growing trend in our industry,” said Perez.

“We are agnostic in terms of wrappers. We focus on the underlying strategy, portfolio or investment theme the client wants to have access to. Then, you can use a variety of wrappers, not just notes or CDs but also UITs, annuities, ETF’s and ETN’s.”

“Our industry is moving in that direction,” agreed Lotenberg.

“We will likely see more and more of that in 2015. Investors want opportunities in their portfolio. The package in which it’s delivered doesn’t matter so much to them.”

Regardless of what the market will be this year, sources are confident that structurers will meet demand in a variety of scenarios.

“I think our industry is creative enough to adjust to most market conditions,” said Koo.

Only tail risk events such as Lehman Brothers demise or negative headlines around improper sales of products could have a negative impact.

“I certainly hope that it won’t happen.

“Any changing market condition is not going to affect our industry that much volume-wise. It may change the types of products and underliers, but not necessarily the pace of issuance. This is why I am relatively optimistic for 2015.”

Merrill, the engine

BofA Merrill Lynch, as the top agent in U.S. structured notes, is a main contributor to volume growth.

The size of its notional, its market shares and the pace of its rollovers will dictate a large part of the upcoming year’s volume.

“Volume is a reflection of what the big firms are doing when they distribute directly to private wealth management divisions,” said Tessar.

“2014 was a good year for us and for the industry,” said O’Neil.

“We’ve been in this business for a very long time. We’ve earned the trust of our financial advisers. That’s the only way you can get them to do business with you.

“The source of our success has been consistent year over year. We have the best financial advisors, we sell our notes in a consistent portfolio context, and we have local specialists who meet and know the financial advisers, giving us their feedback, which enables us to deliver products based on clients’ needs.”

Despite some pricing impediments, the Merrill Lynch “machine” continued to deliver, selling $11 billion last year as of Dec. 17, a figure that does not take into account its closing week of the year at press time.

“Despite the fact that we still have low interest rates and low volatility, we have a program that delivers simple, popular products in a repeatable way,” said O’Neil.

“Low interest rates are not helping, but they’re not such a huge impediment. What really helps our business is education, acceptation of the products and understanding of the structures.”

Rollovers are a key element to sustained growth. O’Neil is optimistic for the year to come.

“We have a fairly good roll capture. It can be significant, up to 70% or 80%. People who buy the products tend to buy them again. We think it will keep our volume high this upcoming year,” he said.

The large majority of Merrill’s products are based on equity indexes. The firm is considering expanding to other asset classes, a move that may not happen in 2015, however.

“We are equity-oriented but we tend to use indexes more than stocks. We strive to offer participation,” said O’Neil.

“We run the most boring business in the industry. But we have repeated formulas that work quite well. We have a concentration in equity notes.

“We’d like to diversify more. I would love to have a more robust fixed-income platform, but there’s got to be a value proposition in everything we offer. Right now we don’t see anything very compelling in the fixed-income space.

“When we put money at risk we want to see the potential for significant outperformance.”

Popular structures in 2014

Autocallables and reverse convertibles have been the fastest-growing structures last year.

As volatility was low most of the time, single-stocks were popular as the fuel for yield-enhancement.

“Investors concentrated on equity linked structures, mostly short term autocalls,” said Chancay.

“We saw quite an uptick in the reverse inquiry for autocallables. We priced very specific deals for our own clients,” said Tessar.

Autocallable reverse convertibles saw their volume surge by more than 30% in 2014, making for one-fifth of the overall volume sold.

“Single stock autocallables were the growth story of 2014,” said Perez.

“Investors were confident that the underlying stocks would continue to go up. They were anticipating that they would be called. The fact that those products are income-bearing and that they’re usually shorter-dated made them all the more popular.”

Some investors however are beginning to be concerned about reinvestment risk after the autocall is triggered, noted Koo.

Higher rates could make those income products less popular, some said.

But with rates still very low and despite the Fed’s likely hikes ahead, many predict that issuers will continue to find creative ways to enhance yield as investors will still starve for it.

Chancay cited the example of CMS-linked steepeners and range accruals, in which equity downside exposure was incorporated as a way to enhance coupon yield.

Tessar said that “the popularity of the steepener trade was a big surprise for me,” since he anticipated the curve to flatten rather than steepen in the years ahead.

He anticipates this year more barrier range accrual notes with an equity component.

“We’ve seen a lot of those tied to indexes, the Russell 2000 for instance. You keep earning a 7% annual coupon as long as the index stays above 70% of its original level. It could be a daily accrual, or quarterly observation or just prior to the pay date. You just need to be within the range at that time.

“Regardless of the way those products are structured we’ll continue to see more demand for it as yield enhancers.”

Indecisive or range bound investors may make tactical bets using leveraged buffered products, as those notes outperform when the index moves within a range regardless of its direction.

But just like buffers were hard to price last year due to low volatility, leverage may become the other harder-to-structure piece of a deal if volatility picks up.

“I don’t think leverage will win the day as it has this past year. Call options may become too rich if we have a sell-off,” predicted Styrcula.

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