Issuers innovate with customized baskets and delta one strategies despite seasonal slowdown

By Emma Trincal

New York, June 18 – Amid a slow summer week, issuers brought to market larger deals focused on targeted strategies achieved through simple trackers based on customized baskets, data compiled by Prospect News showed.

Baskets of stocks, equity indexes or exchange-traded funds are one of the most recent trends seen of late, sources said.

Investors are ready to give up optionality for the benefit of access to hard-to-find strategies or baskets, they noted.

Volume last week amounted to only $331 million, which was 6% lower than the prior week, according to the data. The number of offerings dropped to 83 from 115, but deals were larger in size with six of them over $20 million in the week ended Friday versus none in that category during the first week of June.

Three deals caught the market’s attention last week. They were all trackers structured around a very specific, customized basket that differed from the traditional equity benchmarks or commonly used single stocks.

“We’ve seen funds or index deals being more pinpointed to certain areas or sectors. Issuers are targeting themes that are much more intricate,” said Andrew Valentine Pool, main trader at Regatta Research & Money Management.

Emerald

Last week’s largest offering was an example.

Deutsche Bank AG, London Branch priced $46.1 million of 0% tracker notes due June 15, 2034 linked to a basket including a volatility index and two global equity ETFs.

The product was a tracker giving investors exposure to the return of the Deutsche Bank Equity Mean Reversion Alpha Index Emerging Markets (Emerald EM) and the return of an equally weighted sub-basket consisting of the iShares MSCI EAFE ETF and the iShares MSCI Emerging Markets ETF

The payout at maturity will be par plus the basket return.

The notes will be called if the basket level falls below 40.

Deutsche Bank Securities Inc. was the agent.

Tail risk hedge

Deutsche Bank’s Emerald index aims to measure the spread between the daily and weekly variance of the S&P 500 on a rolling weekly basis. The index is designed for sophisticated investors and offers volatility-based tail risk protection, according to a Deutsche Bank paper on tail risk hedging. The algorithm seeks to capture returns based on the S&P 500’s tendency to “mean-revert” during the course of a single week. The strategy as such can generate returns while providing downside protection.

“I’m not familiar with the Emerald, but we see a lot of interest from investors in putting in place strategies around volatility,” a sellsider said.

“With volatility across asset classes so low, an increasing number of people are interested in getting exposure to long realized volatility. But there is a carry cost to do that. Some investors come to us specifically to get exposure to long volatility but need to see a decrease in the carry cost.

“I haven’t seen the deal, so I’m not sure whether adding the two ETFs is a way to do that. It very well could be.”

Italian pair

Even more unusual was a pair of deals brought to market by Goldman Sachs Group, Inc. that offered exposure to exactly the same stocks contained in a country index but via a basket whose unique purpose was to change the weightings from the way they were set in the index, at the request of the investor, a source said.

Goldman Sachs priced $38.8 million of 0% notes due Dec. 15, 2015 linked to a basket of the shares of the 24 Italian companies included in the MSCI Italy index. It was the No. 2 offering last week in size.

The basket was comprised of 26 ordinary shares and savings shares of all the 24 Italian companies that constitute the index.

The difference between the index and the basket was the weighting scheme. The MSCI Italy index has a high concentration in certain stocks. Eni SpA, for instance, is the top holding and has a 19% weighting in the index.

The issuer changed the rules for the basket, limiting the weightings of the shares to a range from 0.325% to 5%.

“There were so many of the same deals last year, like the same stocks over and over, the same S&P, same Euro Stoxx. A deal focusing on Italy only is much more specific,” Pool said.

“We wouldn’t mind doing ourselves a deal including Italy. Not Italy alone, but for example a basket that would hold Italy, Spain and emerging markets.

“We like Italy for its financial sector. Italy has been up a lot this year, but it’s one of the stronger markets we would be taking some risk on.

“However, the idea of using Italy alone as an underlier would represent too much concentration risk. We would take Italy in a basket but would add other countries or regions as a way to spread our risk.”.

Goldman Sachs priced the fourth offering in size with its second “Italian basket” deal, which was nearly identical to the first one aside from its $30.56 million size and maturity date of Dec. 17, 2015. The issue price was 99.13% of par for this deal and 99.18% of par for the other deal.

Customized baskets

“Different investors have different views on stocks, and some may prefer to have different weightings than what’s in the index,” the sellsider said.

“They may like some stocks but not their weightings. They may want to get exposure to the index in a customized basket. We’re seeing more and more of this.

“There is also the mandate issue for pensions or institutions. You may have in the index some holdings that do not fit the socially responsible requirements imposed by the mandate.

“It could be a number of things. It could be a risk-management strategy. They’re looking at mitigating the concentration risk in the weightings.

“Or it could be pure stock picking. They may prefer certain stocks over other stocks or get more concentration in some sectors rather than others.

“What they’re simply doing is taking advantage of one of the benefits of structured products. If you have a view, you can create your own.”

Pool said that besides changing the weightings, some investors are motivated to use baskets because they want exposure to a geographic area but only with a subset of the countries composing the regional index or ETF.

“People don’t want to be trapped into one index. Instead of investing in a Latin America stock index, they may want to pick Mexico and Chili, two of the best-performing countries. They’re getting more of a focused approach on a specific index,” he said.

“Picking country indexes or sectors within an index is definitely a trend that we’re seeing right now, and it’s growing.”

Trackers

The Deutsche Bank deal and the two Goldman Sachs basket deals had one thing in common: their delta one payout, sources noted.

The three deals made for 35% of last week’s volume, representing a total volume of $115 million in trackers.

Investors are increasingly attracted to those deals, which offer no optionality but a simple one-to-one exposure on the downside and on the upside.

Trackers’ issuance volume so far this year has doubled to $1.55 billion from $773 million last year. This structure type represents more than 8% of total volume for the year to date versus 4.5% last year.

“The only time we do delta one deals is when the underlying is tied to something we can’t readily buy in the market,” said Pool, adding that the change of weightings for the Italian baskets and the complex basket in the Deutsche Bank offering were good examples.

“It should really be to get exposure to asset classes that are hard to get access to, for instance if there’s no ETF for that particular market or strategy.

“Why else would you tie your money to structured products with the extra cost if you could just buy an ETF with a stop loss? The whole idea behind structured products is to get something more advantageous than the holding itself.”

Yield theme

Income remained an important theme last week.

“We’re still seeing a lot of flow from investors selling volatility to generate yield enhancement. Yield is still an important aspect of structured products,” the sellsider said.

Investors used autocallable reverse convertibles, reverse convertibles or autocallables in an effort to secure higher yield. Sometimes hybrid structures prevailed.

An example, and the third largest deal last week, was Bank of America Corp.’s $35.11 million of 9% STEP Income Securities due June 26, 2015 linked to the common stock of Valero Energy Corp. If the stock finishes at or above the step level of 109% of the initial share price, the payout at maturity will be par plus 3.54%. If the stock finishes at or above the initial share price but below the step level, the payout will be par. Investors will lose 1% for every 1% decline in the stock.

“Rates will go up but not any time soon. Investors are more ready to take on risk than they were a year ago,” Pool said.

Summer begins

While issuance volume continues to hold up on a year-over-year basis, the uptrend is showing signs of weakness, according to monthly and weekly figures.

Volume this year has grown by 13% to $18.99 billion from $16.80 billion.

But at $683 million as of June 13, sales this month are down 12.35% compared to April’s equivalent period, which showed $779 million of sales, according to the data.

The first and second weeks of June are at the bottom of the list of weekly totals, the data also showed.

“We think it’s a seasonal slowdown. We’ve noticed it for the first time this month, somewhere in June. Issuance volume started to be thinner, and the normal trading volume in the markets in general was also slower,” Pool said.

The sellsider attributed variations in the issuance pace to retail.

“Our institutional flow doesn’t show any changes. It’s consistent with what’s typical: no more, no less,” he said.

BofA Merrill Lynch was the top agent last week with $89 million in five deals, or 27% of the total. It was closely followed by Goldman Sachs with 26.2% of the total. Deutsche Bank was third.

“Issuers are targeting themes that are much more intricate.” – Andrew Valentine Pool, main trader at Regatta Research & Money Management

“Yield is still an important aspect of structured products.” – A sellsider

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