ETFs, indexes are the bright spot in an otherwise dull market; sales down 20% year to date

By Emma Trincal

New York, Aug. 8 - Agents have sold $21.78 billion of structured notes this year through Aug. 4, down 20% from the $27.18 billion sold last year as of Aug. 4, according to data compiled by Prospect News. The number of deals grew to 4,896 from 3,817.

Just about all asset classes have declined in volume except for equity indexes, up 25%, and exchange-traded funds, up 22%.

Leveraged notes with buffers or barriers continue to be the preferred structure along with delta one products, according to the data.

ETF-linked notes made a spectacular push last week, growing 138% to $50 million from $21 million. In notional amount, the asset class remains very small, but deals in that category made for almost 15% of the volume last week.

Last week was both the end of July and the start of a new month. Sources said that most of July's pricing had been done during the prior week, which the data validates.

Agents sold $344 million in 109 deals in the week ended Aug. 4, compared with $1.09 billion in 272 offerings during the week ended July 28, a 68.5% decline.

A month-to-month comparison is skewed by the Fourth of July holiday. As a result, the data showed that volume increased by 154% to $163 million for Aug. 1 to Aug. 4 from $65 million for the same four days in July.

More worrisome is the 28.5% decline from the first four days of August 2011 to the same period of time this year, although last year's period fell into four weekdays.

ETF bid

Equities are down 7% year to date at $16.66 billion. While equity indexes have been known to be resilient, a less-known trend is the growing popularity of notes linked to equity ETFs, even if their issuance volume remains modest.

A structurer explained the different forces behind the ETF momentum.

"It reflects the explosive growth in the ETF market. We are seeing a widespread adoption of ETFs. Despite the uncertain investment climate, ETFs are getting a lot of market shares. They can be traded on the exchange; they are highly liquid; they are good underlyings," he said.

"Also, if you're looking for a niche market, ETFs are the easiest underlying to use in a note.

"Finally, an issuer needs a license to use an index. You don't have that with an ETF. For all practical purposes, it's like trading a stock."

Leveraged notes with partial downside protection remain the most sought-after products.

They represented 43% of last week's volume, dominating other asset classes. On a year-to-date basis, these notes account for 20% of the total and have grown by 19%.

"It really is a difficult market environment for structured notes. It's hard to make principal-protected products," the structurer said.

"You're left with non-principal protected, and the most popular of these are the leveraged buffered notes. It's pretty straightforward: the maturity is not too long, it's simple to explain, and it's been seen for years."

Sell-off wanted

Despite these consistent bids, market participants are concerned about the weakening of the structured products market seen over the last few months.

"It's still very quiet. We don't see very good volume. Things may happen after this summer when everybody is back to work," said Tom May, partner at Catley Lakeman Securities.

Investors are also confused about the durability of the current bull ride, which has lifted the S&P 500 index by nearly 10% since the beginning of June.

"The markets have gone up. People don't believe in the rally. They are wary about trading anything right now," May said.

"Volatility has dropped, so it hurts volatility products such as reverse convertibles and autocallables. Interest rates keep falling. All these factors hamper the normal flow of issuance."

May said that issuance is likely to improve if the market falls and volatility picks up, adding that a sell-off is just around the corner.

"Nothing is ever fixed. Things change. We'll get a market sell-off and we'll start doing some business. The next big macro theme is the U.S. elections. It will start to ramp up over the fall as the fiscal cliff gets at the forefront," he said.

"People are going to realize that it's a very serious issue before the end of the year. In September, the market is probably going to be more turbulent. Once you have a sell-off in indexes and volatility pops up, you get better entry levels. Right now, nothing is easy. The market is going up and down and up and down. It is very range bound."

Interest rates

The structurer said that for volume to pick up again, a delicate balance in interest rates would need to happen.

"There is a double edge. When rates are too high, you buy a bond. A bond gives you a better value proposition. Right now, rates are very low. Structured notes offer a little bit of a value proposition compared to Treasuries. But it's very hard to make the pricing work," the structurer said.

"It's the middle ground that could make structured notes compete better with bonds," he noted.

"First, you need ... rates to go up a bit but not explosively. Second, you need some consensus on where the market is going. Right now there is no clear theme; there are no new opportunities that people can see."

Headlines and political risk continue to weigh on visibility and investor conviction, said May.

"The market is completely politically driven, not driven by an economic rationale. There is so much intervention from central banks and governments, a lot of variables could go wrong. Trying to choose when to enter in this market is very difficult. That's why the volume is so slow," he said.

"On top of it, you have credit risk issues. Banks are doing a great job marketing themselves. It's bad news after bad news. You had the Libor scandal involving Barclays; then HSBC pops up with money-laundering charges; and now Standard. It doesn't predispose people to do business with banks, does it?"

Top deals, agents

The top deal last week was Barclays Bank plc's $63.68 million of 0% buffered return enhanced notes due Aug. 21, 2013 linked to a basket of five Asian indexes and their related currencies.

It offers two times leverage on the upside up to a 14% cap. There is a 10% buffer on the downside with a 1.111% downside leverage factor beyond the buffer.

Barclays and JPMorgan were the underwriters.

JPMorgan sold the No. 2 deal, HSBC USA Inc.'s $30 million of 0% return enhanced notes due Aug. 8, 2017 linked to the S&P 500 index. The product offers a 185% participation rate with no cap and no downside protection.

The third offering was a $17.07 million reverse convertible linked to Las Vegas Sands Co. brought to market by Citigroup Funding Inc. It has an 11.5% coupon and an 80% barrier on the downside.

Barclays was the top agent last week with $98 million in 15 deals, or 28.39% of the total. It was followed by Morgan Stanley and HSBC.

"People don't believe in the rally. They are wary about trading anything right now." - Tom May, partner at Catley Lakeman Securities

"Trying to choose when to enter in this market is very difficult." - A structurer

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