Instead of offering long tenors, structurers are reducing protection

By Emma Trincal

New York, April 26 - Issuers facing pricing hurdles caused by low interest rates are increasingly offering partially principal-protected notes, which may return less than 100% of principal at maturity, sources said.

Many of these recent structures promise to pay a minimum of 80% to 95% of principal back. The advantage compared to a fully principal-protected note is that issuers are able to offer investors products with a much shorter duration, said a New York sellsider.

"You can't offer full protection on a two-year note. Interest rates are way too low.

"The only way you can do a 100% protection is with a five-, seven- or even 10-year maturity. And clients don't want those long tenors anymore. They're concerned with liquidity risk.

"Issuers had to find new ways to price principal-protected products in a low interest rates environment. One way to do it is to reduce the amount of protection.

"With an 80% protection, you can easily offer a two-year note."

Especially FX

A recent example of this structure is HSBC USA Inc.'s planned 0% emerging markets Currency Accelerated Return Securities due May 1, 2013 linked to a basket of equally weighted currencies.

The underlying currencies are the Brazilian real, the Indian rupee and the Chinese renminbi, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 160% to 190% of any basket gain, with the exact participation rate to be set at pricing.

Investors will be exposed to losses of up to 10%. The minimum payout is $900 per $1,000 principal amount of notes.

Data compiled by Prospect News shows that agents priced 26 partially principal-protected notes between Jan. 1 and April 15.

Nearly half of the deals had a 90% principal protection while the others had either a 95% or 80% protection level.

The average tenor was two years, and the average upside leverage factor was 1.53.

About two-thirds of the deals were found in the currency asset class, and equity indexes represented the rest.

"I'm not surprised that you see more of it in currency deals. Options on FX baskets are very expensive, so you have to lower the level of protection when you take into account the cost of the zero[-coupon bond]," the sellsider said.

Low rates impediment

Whether they protect 100% or less of the capital, principal-protected notes are structured by combining a long call option with a zero-coupon bond, a structurer explained.

The call option provides investors with exposure to the underlying. The zero-coupon bond provides the principal protection. The payment of the option is generated from the difference between the discount price of the bond and par value.

When interest rates are low, the discount decreases, reducing the amount of funds available to purchase the option, he explained.

"With low interest rates, you have nothing left to buy the call option," he said.

"The more interest rates decrease, the more expensive it becomes to structure a principal-protected note."

Yet, structurers still need to purchase the call because the option is what gives investors participation in the risky asset, he said.

"Every issuer struggles with the same issue: they don't have enough interest rates to play with," he noted.

Participation rate

When the cost of the option increases, the participation rate offered to the investor will decrease accordingly, he said. It can even happen despite the extension of the tenor because there is a cost of being long an option.

"You add for instance one year. But it's not a simple solution. Say that your call option cost 3% and you get 1.5% in interest for going one year longer. If your cost to buy the additional call is higher that the return on the additional interest, then your participation rate has to get lower. It's been happening," he said.

The participation rate is the rate at which the investor participates in the positive return, if any, of the underlying. Offering less than 100% participation is not a very popular feature, sources said.

Make it short

Diminishing the amount of protection serves two purposes: keeping the participation rate at 100% and being able to offer a short duration, the structurer explained. Of course, the drawback is that a portion, albeit a small one, of the capital is now at risk.

"One way to avoid reducing the participation rate is to decrease the level of capital guarantee you're entitled to get at maturity," he said.

"If the option cost more than the amount of interest available, I will lower the amount of protection. That way, I free up funds to purchase the call."

Obviously, this solution puts some of the capital at risk.

"But you can shorten the maturity from say, two year to one year or nine months.

"Instead of leaving the strike of the call at par, we lower it at 90%. As long as your call is in the money, you can still get 100% of your principal back," he said.

This structurer said that partially principal-protected notes are attractive for investors who want to know in advance how much they can lose in the worse-case scenario while maintaining a 100% participation rate on the upside.

"You could place a stop loss, but the stop loss gets exercised right away. Once you hit a stop loss, then you're out of the market," he said.

"With this product you could lose 10% but come back and recover. You don't get kicked out."

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