Volume hits $453 million with heavy flow in stock deals amid earnings season, volatility spike

By Emma Trincal

New York, July 23 – Issuers tapped into so-called “momentum” stocks last week in the middle of the earning seasons in an effort to generate better payouts in a market dominated by single-stock deals. Separately, issuers are striving to use techniques such as downside leverage in a similar attempt to boost the risk-return profile of their products, sources said.

Agents sold $453 million in the week ended Friday versus $793 million the week before, according to data compiled by Prospect News. For the month as of July 18, sales have grown nearly 50% to $1.55 billion from $1.05 billion for the same period of June. For the year, volume has risen by nearly 15% to $22.87 billion from $19.95 billion during the same time last year.

“It’s hard to identify a trend over small periods of time. The year-to-date increase, however, is a good sign. It’s pretty good that we’re still up given what volatility has been,” said Joe Halpern, chief executive of Exceed Investments.

“I’m optimistic for the remainder of the year. I think we’ll see a few more good notes.”

Some industry participants said the recent highs in the equity market are a deterrent to structured notes investing as clients may prefer to be long the market. Halpern said he disagrees.

“As the market keeps going up, investors are finding structured notes convenient as a way to define their own risk-return profile,” he said.

“You don’t necessarily have to include downside protection if you’re bullish. You can get leverage on the upside instead or a higher cap.”

Small trades

The number of larger offerings (in excess of $10 million) was limited last week to 11 out of a total of 149 deals.

The largest deal was Barclays Bank plc’s $41.76 million of 0% synthetic convertible notes due July 23, 2021 linked to the common stock of International Paper Co.

Single stocks made for an unusually large proportion of last week’s action with $270 million in 108 deals, or 60% of the total. Even without the largest deal, the asset class still accounted for half of the total volume. Ninety six single-stock deals were small – below $5 million in size, according to the data.

“I’m not sure small is a new trend. Most structured notes are usually small trades. But some firms have pushed into that niche more than others. UBS is the top example. They’ve created a platform and introduced some level of automation,” Halpern said.

“Even without a platform, firms are able to price smaller deals. Once you have the structure in place, it’s probably easy to price stuff, it doesn’t cost a lot. It’s the nature of the beast.”

UBS last week priced half of the less-than-$5 million stock deals. It was followed by JPMorgan, which did almost a quarter of them. The other player was RBC.

Agents used primarily autocallable reverse convertibles structures (45% of the total volume) to price those stock-based products.

The main deal in this category and the second largest to price last week was Royal Bank of Canada’s $29.1 million of contingent income autocallable securities due July 21, 2017 linked to the common units of Blackstone Group LP.

The coupon threshold is 80% of the initial price with quarterly observation dates and a 12.25% contingent coupon per annum. The notes are callable above par. At maturity, investors are exposed to full losses below the threshold.

Morgan Stanley Smith Barney LLC handled the distribution.

In the No. 4 deal of the week, Credit Suisse AG, London Branch priced $20.79 million of 8% STEP Income Securities due July 31, 2015 linked to the common stock of Amazon.com, Inc.

If the final price of Amazon.com stock is greater than or equal to the step level, 108% of the initial share price, the payout at maturity will be par of $10 plus the step payment of 2.82%.

If the final share price is greater than or equal to the initial share price but less than the step level, investors will receive par.

If the final share price is less than the initial share price, investors lose all protection.

BofA Merrill Lynch was the agent.

Playing momentum

Whether small or big in size, a majority of those single-stock names were “momentum stocks.” Those tend to be popular stocks in the technology or biotech sectors, where volatility levels are higher than in other parts of the market.

“Playing on momentum has always been a way to get higher yield or more upside,” said Halpern. “The market has been a little bit choppier recently due to geopolitical events as well as the crisis in some of the largest Portugal banks.”

Among the names used last week as underliers were Amazon.com, Facebook, Inc., Tesla Motors, Inc., Apple, Inc., Twitter, Inc. and Biogen Idec Inc.

Energy plays were seen as well with names showing implied volatility over 30%, such as Petroleo Brasileiro SA and Valero Energy Corp.

“Volatility gives you the highest coupons. It’s especially useful with those stock deals when you’re short volatility,” a sellsider said.

The Fed helped volatility surge on Tuesday. During testimony before Congress, chair Janet Yellen spoke about momentum trades, saying that valuations in some sectors such a social media and biotechnology appeared “substantially stretched” despite a sell-off seen earlier in the year.

The S&P 500 dropped by more than 1% as a result.

“Volatility, which hit new lows in the beginning of July, has now moved up a little,” said Halpern. “In the middle of last week, the VIX index surged by 30% in just one day.

“Between this volatility pickup and the earnings cycle, you can optically better the characteristics of some of those deals.

“If you pick one of those small volatile names and decide to do a one-year step-up or whatever it is, and if you time your pricing just before the earnings when volatility moves up, you can certainly take advantage of the higher premium to get more attractive terms if you are a long-term player.”

Volatility, however, remains low. Issuers see it as a major obstacle when trying to price attractive products.

“The record-low volatility is very hard to explain,” the sellsider said.

“It’s not just in the U.S. where you can explain it as a result of the Fed’s policy. It’s a worldwide problem.

“Look at oil. I was talking to a colleague about crude oil. You have the civil war in Iraq, the war in Gaza. You would expect to see a lot of volatility in oil and tons of oil-based products. But it hasn’t been the case. I have no idea why.”

Geared buffers

To overcome the low volatility impediment, issuers have used old or newer techniques, leading some to believe that the banks are becoming more creative in the way they structure their products.

One technique widely employed last week was the use of downside leverage or so-called “geared” buffers. Goldman Sachs, Credit Suisse, UBS, RBC and Deutsche Bank brought to market such deals.

“I know that certain banks, for instance Goldman, do these more than others. Certain firms don’t hesitate to lever the downside while others tend not to, perhaps because they strive to keep their notes simple,” Halpern said.

“Conceptually, the geared buffer should help improve the terms of a structure.

“If you take a leveraged note with a 10% straight buffer, you get one time below that. If the underlying asset drops by 15%, you would lose 5% with this instrument. Now, if you lever the buffer by 1.11, your loss would be 5.55%, so you have more than half a point extra to play with.

“I’m not sure how investors feel about it, but it definitely gives you better upside.

“If it matches the characteristics that they are looking for in a product based on their belief, expectations of the market, it can be a good solution. It definitely has value.

“Everything is about the risk-return payoff. However, if it’s too complex, it’s a problem.”

Balancing act

In general, Halpern said that issuers have become more creative in the way they construct their products simply because they have no choice when facing the challenging pricing environment.

A delicate balance, however, has to exist between innovation and complexity in order for firms to be able to market the newer, smarter products, he noted.

“We’ve seen intriguing structures, such as the five times leveraged notes a few weeks ago. Those may make sense depending on your view,” he said.

“If you’re pretty bullish, you may want to lower the leverage and raise your cap. That’s the beauty of structured notes. You’re really able to create the product that matches your view. If you need protection, you’ll get a barrier or a buffer. If you don’t want protection, you can improve some of the characteristics on the upside.”

Sometimes, the structure does not have to be complex. The ability to gain access to an index or asset class is enough to entice buyers, he said.

“We’ve seen last week trackers on the DAX index. There are a lot of reasons to use a structured note versus a fund when there is one. Access is one factor among others,” he said.

Innovation

“We’re seeing a certain number of innovative structures. A couple of months ago, we noticed a very short-term deal with a three-week observation date. During that time, if the index dropped below a certain level, you were set to receive more leverage than if it ended above the threshold. This was a pretty unusual structure. It was small but very innovative,” Halpern said.

He was referring to Morgan Stanley’s $1.09 million of 0% return enhanced notes due Aug. 27, 2014 linked to Cabot Oil & Gas Corp., which was sold by J.P. Morgan Securities LLC in May.

“Issuers are becoming more innovative in general. They have to in order to figure out ways to price products that look good,” he said.

“I don’t know if they’re successful at selling them to a wide variety of investors. A product like this [Morgan Stanley deal linked to Cabot], for instance, I can’t imagine it becoming standard.

“If a product is too clever, it becomes harder to sell. Innovative products don’t tend to become standard. They’re too bespoke, too hard for people to understand. Those notes are usually the result of reverse inquiries, with people asking for certain things in a very specific way.”

The sellsider said he has not noticed more innovation on the part of the banks.

“I don’t think issuers are especially creative. They’re forced to make a few changes to shorten the maturities as investors are reluctant to go beyond two to three years. They have to find solutions to the low vol problem. But I don’t see major changes in the way products are being structured,” he said.

The top agent last week was JPMorgan with $94 million in 36 deals, or 20.70% of the total volume. RBC and Barclays were No. 2 and No. 3, respectively.

“Investors are finding structured notes convenient as a way to define their own risk-return profile.” – Joe Halpern, chief executive of Exceed Investments

“The record-low volatility is very hard to explain.” – A sellsider

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