Large deals linked to single stocks hit the market as investors continue to seek higher yields

By Emma Trincal

New York, Jan. 28 - Unusually large single-stock-linked notes with fixed or contingent coupons have priced recently, a sign that the hunt for yield continues to be a driving force for investors in a record-low interest rates environment, sources said.

"People are nervous with their fixed income, but they still need their fixed income," said Carl Kunhardt, wealth adviser at Quest Capital Management, commenting on five offerings that priced over the past two weeks ranging from $21.27 million to $51.39 million. The products were all linked to single names and structured as reverse convertibles, autocallables or a variation of reverse convertibles.

"Those products look, walk and talk like fixed income but actually aren't fixed income," he said.

"They're unsecured debt. You don't have the same place in the capital structure as you would have with a regular bond.

"But in the world of zero interest rates, a 2.25% per quarter looks very attractive," he said, citing the contingent coupon offered in one of the recent deals.

RBC's $51.39 million deal

The top offering was a reverse convertible with a 5.42% buffer. Royal Bank of Canada priced $51.39 million of 8.5% coupon-bearing notes due Jan. 27, 2014 linked to Valero Energy Corp. shares, according to a 424B2 filing with the Securities and Exchange Commission.

Interest was payable quarterly.

If Valero shares finished at or above the threshold level - 94.58%% of the initial level - the payout at maturity would be par of $10. Otherwise, investors would be exposed to losses beyond the threshold level.

Bank of America Merrill Lynch was the agent.

"It's pretty plain vanilla, but it's not my favorite one," Kunhardt said.

"The underlying theme is oil. Assuming that we develop even a fraction of the oil reserve that has been discovered, even a fraction of the shale fields, the price of oil is not going up anytime soon.

"Also, I'm not going to make a decision based on the protection level. With a 5% buffer, you might as well have no buffer.

"There's nothing to dislike about this deal. The underlying theme does not intrigue me, that's all."

Bulls go to Vegas

The second deal was an autocallable product also issued by RBC, $35.21 million of contingent income autocallable securities due Jan. 27, 2014 linked to Las Vegas Sands Corp. stock.

The downside threshold was 70%, which triggered a contingent payment of 3% on each quarterly observation date that the stock closed at or above that level. The 70% threshold also served as the final barrier level below which investors were fully exposed to losses. The notes were to be called on any of the quarterly determination dates if the stock was at or above its initial price.

The agent was RBC Capital Markets, LLC with Morgan Stanley Smith Barney LLC handling distribution.

Kunhardt said that he liked the underlying name and sector of this deal but for a bullish client.

"I like that [it] is a one-year for something that aggressive. The fact that it's callable doesn't bother me. The 12% coupon is fairly high, and I like the 70% barrier," he said.

"More than the terms, what I like in this deal is the underlying theme. If you're bullish and you think that people are going to spend money, if you believe that consumer confidence is coming back, then it's a fine play.

"The first thing people spend money on in a recovery is gambling. They buy their half gallon of milk, their cigarettes and their lotto ticket. This country is addicted to gambling.

"Las Vegas is one of the most depressed areas in the housing market. You could combine this trade with REITs targeting this area if you're dealing with an aggressive client looking for opportunities," he said.

Hybrid on Apple

Goldman Sachs Group, Inc. brought to market a hybrid structure that combined the fixed coupon seen in reverse convertibles with some upside participation albeit up to a cap.

Goldman Sachs priced $29.87 million of mandatory exchangeable notes due July 29, 2013 linked to the common stock of Apple Inc.

The six-month notes carried a coupon of 10% per year. Interest was payable quarterly. There was no downside protection, but the payout at maturity gave investors participation in the final share price, subject to a cap of 111.25%.

The underlying stock tumbled on Thursday as a result of Apple's earnings released after the close on Wednesday, which disappointed investors in terms of iPhones sales. The share price dropped by nearly 10% on Thursday. But the deal priced two days prior to the sell-off on Tuesday at $504.77.

"It's nice to have a potential upside of 10% in coupon plus the 11% in capped participation. But you get that because there's no downside protection, that's why. The amount of extra upside is not going to make me change my opinion," Kunhardt said.

In this case, the short duration was a disadvantage in his view.

"The stock tumbled, but analysts have crazy expectations. They need to get their heads out of the sky and get back to earth. No stock could have continued in that trajectory. But Apple is not going away. It's a mature company," he said.

"That said, this note is a six-month and I don't feel that confident about Apple in six months. I would prefer a point-to-point after 12 months. But six months is not even a full consumer cycle. There really isn't a trigger to pop the price up in the next six months."

Scott Cramer, president of Cramer & Rauchegger, Inc., said that income products as seen last week demonstrate the willingness of investors to take more risk. But he questioned whether the risk was understood.

"These income structures used to be done on baskets of stocks or indexes. Now [issuers] have to use stocks to find options cheap enough, and as a result you're getting less diversity in your portfolio," Cramer said.

"The reason those products are selling is because people need the income. But I don't think they understand the potential downside. Those products have a lot more risk than the ones we used to see, those products that had true barriers or principal protection. Unfortunately, those aren't there anymore.

"I understand why the market is moving into that direction. Interest rates are low, option pricing is challenging. But I don't like those products. I don't want to have the stock put on me," he said.

The Goldman Sachs deal on Apple illustrated how risky some of those deals can be, he said.

"This is a pure Apple play. Somebody really needs to know Apple. But a stock like Apple, all of a sudden, can fall dramatically and very quickly as we've seen last week," he said.

For Cramer, betting that Apple shares will remain moderately volatile may not be realistic.

"Apple is the kind of stock that's going to be volatile, because it's so widely held. It goes up and down in momentum. The volatility has proven to be high.

"If you buy these notes, you have to believe that Apple will be north of where you bought it but not a whole bunch north of it.

"While you're getting some participation in the price appreciation, your upside remains limited by the cap. Meanwhile you have unlimited downside. The only reason you would do this is if you think Apple will be relatively stable. If it goes up more than 21%, you wish you would own the stock. If it's less, you wish you didn't."

"And while the six-month term is short, it does not protect you from a sharp sell-off like the one we've had last week.

"You can't get rid of it. You take the liquidity risk. You can't get out," he said.

Two Morgan Stanley issues

Morgan Stanley also brought single-name products to the market with two autocallable offerings last week.

Morgan Stanley priced $32.88 million of contingent income autocallable securities due Jan. 25, 2016 linked to JPMorgan Chase & Co. stock.

If JPMorgan stock closed at or above the downside threshold level of 75% of the initial price on a quarterly determination date, the notes would pay a contingent payment of 2.0875% for that quarter.

If JPMorgan stock closed at or above its initial price on any of the quarterly determination dates, the notes would be redeemed at par plus the contingent payment.

If the JPMorgan stock finished at or above the downside threshold level, the payout at maturity would be par plus the contingent quarterly payment. Otherwise, investors would be fully exposed to any losses.

Separately, Morgan Stanley priced $21.27 million of contingent income autocallable securities due Jan. 25, 2016 linked to Starbucks Corp. stock.

The contingent coupon payable quarterly was 2.2375%. The notes were callable on any of the quarterly determination dates if the stock was at or above its initial price. The final payout was the same with the 75% downside threshold.

"Investors are looking at anything that generates income, but not all products are equally suited to provide capital preservation. I wouldn't find those structured products appealing," said Josh Peters, director of income strategy at Morningstar.

"I'd much rather buy and hold shares of Johnson & Johnson or a high-quality blue chip stock and collect dividends. Yields may not look as attractive, but those stocks deliver more income and reliability over time," he said.

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