Agents price $356 million of structured products for week in rowdy market; autocalls see heavy bid

By Emma Trincal

New York, Oct. 24 – The U.S. structured products market saw a relatively decent volume of issuance last week in the face of a roller coaster market, which began earlier this month and is continuing unabated.

Agents priced $356 million in 152 deals in the third week of the month, according to preliminary data compiled by Prospect News. Figures are subject to upward revisions as not all deals were filed with the Securities and Exchange Commission website at press time.

But for this part of the month, sales are holding up given the broad sell-off that has characterized October so far.

At its close on Friday, the S&P 500 index was down 5.5% from its late September’s record high. This week, as of the Wednesday late afternoon session, the decline was 8.7%.

Volatility continued to rise last week. Rather than a huge drop, the market seesawed in wild moves with the Dow Jones industrial average jumping 500 points on Tuesday only to tumble 300 points on Thursday and recover on Friday, finishing flat for the week.

Market downturn

“People tend to think that when volatility rises, business should be good in structured products because pricing conditions improve. And that’s true...to a certain extent...

“After a while – and it doesn’t take long, if the market continues to deteriorate, people will panic and sell.

“At that point the market hurts everyone, buyers and makers of structured products alike.”

Analysts attributed the turmoil to a number of factors: anxious reactions to third-quarter earnings, higher rising interest rates, the strength of the dollar, concerns over the Federal Reserve’s determination to maintain its hawkish stance and of course, continued geopolitical tensions.

Negative news did not help from a diplomatic crisis with Saudi Arabia to China’s slower growth and a problematic Italian deficit. Adding to the pressure, some disappointing figures in housing led investors to question the economic outlook for the United States.

It is no accident that autocallable contingent coupon structures took precedence last week making for 36.5% of the total notional, according to the data. It was greater than all types of leveraged structures, which accounted for a third of the total.

The appetite for autocallable notes, which in essence short volatility, did not surprise a structurer.

Volatility in backwardation

“Pricing becomes much more favorable for autocalls obviously when volatility goes up like that,” he said.

“But there is another positive factor going on right now: the term structure of the volatility curve is in backwardation.”

He was referring to the different expiration terms of volatility futures contracts, which constitute the term structure. When the curve is downward slopping, it is said to be in “backwardation,” as opposed to the so-called “contango” when the curve is upward.

Backwardation simply means that investors are willing to pay more for short-dated contracts, which reflects their expectation that volatility will rise short-term.

European barriers

“So now you can profit from short-term volatility even with a longer autocall,” he said.

“Some clients don’t want very short-term products. Because when it’s too short, even with higher volatility, you don’t necessarily get those low barriers.

“To have good European barriers, you need to go longer. And with the curve in backwardation you can still profit from the short-term.”

A European barrier is one that is observed point to point. Most U.S. autocallable products are built around European options.

“In normal market conditions, the volatility curve is in contango. It cost you less on the front-end of the curve than on the long-end. Now it’s different. Because the market is a mess, people perceive the risk on a very short-term basis. It adds more efficiency to pricing if you combine that with longer-term products.”

Some autocallable notes recently have featured “American” barriers, which are barriers observable during the life of the notes at various intervals. Those features also allow for deeper protection and/or higher coupons, he said.

Pick your barrier

This structurer wouldn’t encourage his clients to use those barriers.

“Some people worry about the huge amount of autocallables that gets issued. After all, they are a short bet on volatility. What if volatility explodes? One of my answers to that is not to avoid autocalls but to avoid American barriers,” he said.

“American barriers expose you to flash crashes. Also, if you’re dealing with a worst-of, all of a sudden one of your stocks or even one sector index can be badly hit. The option gives you more premium. But your protection can vanish any time.

“That’s why we only use European options and preferably longer terms than just three months or six months. Even if you’re below the barrier, you have time to recover.”

Seeking protection

One trend seen last week was the industry’s efforts to come up with different solutions in order to improve downside protection.

For one thing, the supply of leveraged products was more defensive than usual. Only $5 million out of the $95 million leveraged notes that came out was exposing investors to full downside risk. The rest offered buffers and barriers.

Absolute return deals are increasing in numbers if not always in size.

Finally, another trend observed was the greater acceptance of geared buffers among investors.

“It’s a good way to increase your protection. Optically it’s not as attractive because you’ll have a lower strike with a barrier. But you’ll also have much less risk if the market really goes down. If you want to lessen your volatility risk, you do these geared buffers,” the structurer said.

Yearly volume

Volume for the year to date remains positive. So far, $45.97 billion have been priced in 13,012 deals through Oct. 19, an 11.5% increase from last year’s $41.21 billion, according to the data.

Despite the terrible market conditions, sales in October are better than last month. Volume is up 38.5% to $1.51 billion through Oct. 19 from $1.09 billion in September. The deal count has also augmented from 396 to 528.

Top deals

Credit Suisse AG, London Branch’s $18.76 million of two-year autocallable contingent yield notes linked to the SPDR S&P 500 ETF Trust was last week’s top deal.

The 7% per year contingent coupon is payable quarterly based on a 76.6% coupon barrier. The notes are automatically callable after six months at the initial price trigger. The barrier at maturity is 76.6% as well.

UBS Financial Services Inc. is the distributor.

Barclays Bank plc priced $10.99 million of 18-month leveraged buffered notes linked to the S&P 500 index.

The notes pay par plus 2 times any index gain, up to a 13% cap. Investors will receive par if the index falls by up to 15% and will lose 1.1765% for every 1% decline beyond 15%.

JPMorgan is the agent.

Citi’s steepener

Every now and then a good-size rate deal pops up. It was the case last week with Citigroup Global Markets Holdings Inc.’s $10 million of six-year callable fixed-to-floating rate notes. The return is tied to the leveraged difference between the 30-year Constant Maturity Swap rate and the two-year CMS rate.

The first year’s fixed interest is 5%. After that, the rate will be 10 times the spread between the two rates subject to a 10% cap. The notes are callable after the first year. The payout at maturity will be par.

“I see a lot of steepeners. They’ve been out for a long time,” said Mark Dueholm, chief trader at Landolt Securities.

The popularity of the structure is not directly related to the rise of interest rates.

“Steepeners really are all about the slope of the yield curve.

“The curve has been flattening pretty consistently for months, but in the last month or so it has steepened a little bit.

“You can get a lot better terms than a month ago.”

The top agent last week was JPMorgan with $75 million priced in 29 deals, or 20.9% of the total volume. It included four deals totaling $12 million sold by this agent on the behalf of other issuers, such as Credit Suisse AG, London Branch and HSBC USA Inc.

JPMorgan Chase Financial Co. LLC was also last week’s top issuer with $63 million in 25 deals.

JPMorgan Chase Financial is also the No. 1 issuer so far this year with $7 billion in 1,787 deals.

“The curve has been flattening pretty consistently for months, but in the last month or so it has steepened a little bit. You can get a lot better terms than a month ago.” – Mark Dueholm, chief trader at Landolt Securities

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