As the market fights the Fed, investors are seeking growth, yield in ARK notes, steepeners

By Emma Trincal

New York, March 24 – It was another choppy week in the U.S. stock market, pushing investors to seek protection and defined returns in autocalls more than ever.

The averages ended the week slightly lower after Fed chair Jerome Powell coming out of an FOMC meeting on Wednesday failed to appease inflation fears, vowing instead to support the economy in keeping the Federal Funds rate low.

The result was another bond sell-off on Thursday pushing the 10-year yield to 1.73% and hitting technology sector stocks, which are more sensitive to higher yields.

Income, protection

This recent development led to a renewed interest in steepeners. But since short-term rates remain historically low in part due to the Fed’s dovish stance, the appeal of autocalls remained high.

Investors on the one hand are making bets on a recovering economy in non-tech sectors such as financial, energy and travel stocks, while others are magnetized by the high returns of tech stocks despite heightened volatility in this sector.

Agents priced $115 million of structured products last week in 255 deals, according to preliminary data compiled by Prospect News.

Updated figures for the first week of March showed the sale of $1.032 billion in 252 offerings.

Last week, autocalls made for more than 85% of the total and stocks represented two-thirds of total notional volume.

“I haven’t seen anything like a shift concerning the appetite for autocalls no matter how choppy the tech sector is. People are seeking income,” a market participant said.

January tops

The deal count is increasing fast. So far, figures are not yet final for February. But current available data is already showing that January was the top month on record since 2004, when Prospect News began to compile registered structured products issuance.

The preliminary tally for January is $8 billion in 2,245 deals, which surpassed the second-best month on record – $7.845 billion in December via 2,316 deals.

February 2008, which placed third historically as top month, showed $7.4 billion in only 727 deals. Naturally, average sizes have been shrinking throughout the years from for instance $10 million to $11 million a month in early 2008 to $4 million today.

“Volume today is driven by an abundance of smaller deals in the market,” the market participant said.

“The trend has been toward custom deals. Even if some organizations still have kitchen-sink big calendar deals, most issuers for everyday flows are doing $100,000 to $250,000 on the low end up to $2 million per deal. This will remain the prevalent trend. Issuers will continue to do more deals, driving the size lower.”

Volume is up on a 12-month trailing basis to $70.4 billion from $63.45 billion, an 11% increase. The deal count is 17% higher with 22,488 offerings compared to 19,204 in the previous 12-month period, the data showed.

Despite such growth, advisers still have work to do in educating their clients about structured investments, the market participant said.

“In terms of asset allocation, structured notes are still a drop in the bucket. But we’re getting there. As automation gives issuers the capability to handle much smaller sizes at low cost, advisers can customize more deals, which attracts more participants to the market.”

Tech still sells

The choppy tech-heavy Nasdaq did not stop investors from buying notes tied to technology either through the index itself or via exchange-traded funds and single stocks.

“The Nasdaq has become the go-to underlying when it comes to pricing autocalls. It’s not replacing the S&P, but you see more and more autocalls using the Nasdaq instead of the Dow or the Euro Stoxx,” the market participant said.

The most widely used stocks seen last week in autocallables were Apple Inc., Twitter, Inc., Intel Corp. and PayPal Holdings, Inc.

Tesla, Inc. is a category in and of itself.

In the previous week, GS Finance Corp. priced $34 million contingent income autocallable securities due March 15, 2024 linked to the common stock of Tesla. The three-year note will pay a quarterly contingent coupon of 22.25% based on a 50% barrier, which is also the downside threshold at maturity.

During the same week, Morgan Stanley Finance LLC priced another three-year autocallable deal for $29.94 million tied to Tesla with similar terms (except for the contingent coupon at 2.35%).

While single-stock deals tend to be small, it is not rare to see Tesla notes pricing for more than $10 million on any given week.

Morgan Stanley Finance did another one last week for $10 million.

The ark of innovation

But perhaps the trendiest underlying has been the series of ARK ETFs invariably used in autocallables and enhanced return structures essentially with worst-of payouts.

Created by former hedge fund manager and stock-picker Catherine Wood, those ARK ETFs are actively managed and focus on “disruptive” technologies. Wood launched ARK Investment Management LLC in 2014 after spending 12 years at AllianceBernstein overseeing global thematic strategies.

“Wood is one of those new social influencers. She’s been profiled in Barron’s several times. She’s an icon. The performance of her ARK ETFs has been phenomenal, and even if many are now drinking the cool-aid, people hang in there. She’s got a good pedigree and she popularized this ‘disruptive technology’ wave,” said the market participant.

Wood’s flagship fund, the ARK Innovation ETF, has dropped 26.7% in the past two months as the bond sell-off is hurting the performance of technology stocks. But the fund has gained 255% in the past year.

The notional amount of notes tied to one or several ARK ETFs has been significant for a new asset class.

For this year so far, nearly $100 million has been issued in 97 offerings, according to Prospect News.

But the trend started late last year with JPMorgan Chase Financial Co. LLC, which priced $589,000 of six-year uncapped leveraged worst-of notes tied to the ARK Next Generation Internet ETF, the ARK Genomic Revolution ETF and the ARK Innovation ETF.

The upside leverage was 1.5x and the downside barrier was 80%.

Popular disruption

JPMorgan also priced the largest trade on this asset class last month with another leveraged uncapped worst-of product for $34.25 million. The four-year note was tied to the least performing of the ARK Autonomous Technology & Robotics ETF, the ARK Genomic Revolution ETF and the ARK Next Generation Internet ETF. The upside leverage factor was 1.86 times. Investors have full downside exposure.

More than half of those “ARK” deals provide growth rather than income.

Issuers for the most part have used the flagship fund –the ARK Innovation ETF, whose top holding is Tesla (11% weighting) with the number of holdings comprised between 35 and 55.

But firms have also combined the fund with other ARK funds, such as the ARK Genomic Revolution ETF and the ARK Fintech Innovation ETF.

Another appeal coming from the ARK series is their actively managed nature, positioning the ETFs as close cousins to mutual funds, which are investment vehicles extremely difficult to use in structured notes due to regulatory hurdles imposed by the 1940 Act.

“People looking for tactical plays and income can buy those notes,” said the market participant.

“If the performance starts sinking, the manager can rebalance the ETF. It’s not like an index. They can swap out all the components however they see fit, go all cash if they want to. It’s a similar exposure to a mutual fund. Tesla is down. You buy more. It’s an opportunity to buy on the dips.

“With the ongoing volatility in tech, I think that’s what make those notes exciting.”

Steepeners in sight

As long-term yields have been rising, steepeners have been popping up lately. So far, those notes based on the spread between two Constant Maturity Swap rates were mostly seen in the secondary market.

Steepeners have also become bigger deals.

On March 8, Citigroup Global Markets Inc. priced $15 million of callable range accrual notes due March 10, 2036 tied to the two-year Constant Maturity Swap rate. Three days later, Royal Bank of Canada priced $11 million of redeemable leveraged steepener notes due March 15, 2041 linked to the spread between the 30-year and the five-year CMS rates.

The RBC notes will pay an 8% teaser rate for the first year and then 6 times the spread. The payout at maturity will be par. The notes are callable at par in one year.

“Steepeners have come back,” said a bond trader.

“Advisers are looking at the caps. Some of the terms are not as attractive as one-and-a-half years, two years ago when the curve was flatter. Then issuers were giving you 50 times leverage.

The futures market is pricing a steeper yield curve for a longer period, which is why the terms are not as attractive, he said.

But “demand is coming back” as a result of the spike in long-term yields, he added.

“We’re transitioning from the old to a new administration and from a low to a higher interest rate environment with the potential for inflation,” he said.

“Advisers are looking for ways to protect themselves, and steepeners offer full protection, which is why they’re popular.”

© 2015 Prospect News.
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