Volume, volatility up amid debt ceiling fears, rush to plain-vanilla index deals

By Emma Trincal

New York, Aug. 3 - The structured products market roared back to life last week and saw volume increase nearly three-fold. As investors faced one of the most volatile weeks of the year with the debt ceiling gridlock in Congress, they were seen rushing into large index-based, plain-vanilla deals in a bid for simplicity and transparency.

Agents sold $1.58 billion in 256 deals excluding exchange-traded notes in the last week of July, an increase of 190% from the week before when they priced 92 offerings totaling $548 million, according to data compiled by Prospect News.

Despite the weekly volume spike, which was typical for the end of the month, July's $3.15 billion of issuance is down 5.5% compared to June.

Transparency quest

"Definitely, clients' flows dropped quite dramatically recently," an equity derivatives structurer said. "It has to do with the distressed market."

In reaction to the growing uncertainty, investors favored plain vanilla structures, especially those linked to equity indexes.

"It's been a general trend. People are keen to get into simpler structures," the structurer said.

"In a distressed market, investors want to go to something they understand."

Bank of America Merrill Lynch was the agent for the top five deals of the week, among which the first four were linked to the S&P 500 index and the fifth one to the Russell 2000 index.

Simplicity and indexes prevailed among the big hits.

"You didn't see bells and whistles because you had volatility. No need to complicate the product to make it work," said Jakob Bronebakk, partner at Jubilee Financial Products LLP.

Debt anxiety

Monday started with an equity market sell-off that persisted as of Wednesday.

Volatility rose by 30% as measured by the VIX index, fueling a recovery in reverse convertible and autocallable structures.

"This has been the longest spell of falling market for a year," said Bronebakk.

The sudden uncertainty created by debt concerns may have been a factor for a slower summer than usual.

"Over the past couple of months, we've seen people more anxious about credit risk because of the European debt crisis and also the uncertainty around the U.S. debt ceiling," he said.

Equity index notes exploded in volume to $728 million, more than three times their level of the week before. Notes with equity indexes as their underlying component made for 46% of the total volume, compared with 42% the week before.

"Investors want simplicity, so they choose a benchmark. They know the index. It's a good level. They don't want any surprises," the structurer said.

Still leveraged

Leveraged notes were the most popular structure, making for 24% of the total. Merrill Lynch sold several of those among its top offerings, most of the time in a structure featuring triple leverage and no downside protection.

Bronebakk said that leverage in a troubled market is counterintuitive because "leverage is more expensive when volatility is up."

One reason, he said, may be "a seasonality trend in the month."

Another explanation could be that investors may not yet be deterred from entering the market.

"Our clients don't tend to be day-to-day players," he said.

It could also be that the sell-off offered some good entry points for some investors who already had a clear market outlook.

"With more volatility, a lot of people want an investment to make a leveraged bet. If they have a strong view, volatility is seen as an opportunity, not just a challenge," he said.

"I think overall, people go back to what they're used to."

The structurer said that leveraged structures can be done even in a high-volatility environment. The elimination of the buffer is one part of the story. The cap helps structurers price those deals as well.

"Don't forget it's capped, so it's not the full exposure," he said.

"You have some other elements; you sell an option and buy another one. There are a lot of other factors that can make the pricing work."

Some investors saw buying opportunities.

"With the market sell-off, you get good entry points for leverage," a sellsider said.

Record deal

Combining simplicity, leverage and size, Bank of America Merrill Lynch broke a record selling on the behalf of a Canadian bank the biggest equity index-linked notes offering so far this year and the No. 1 deal of the week.

It was Royal Bank of Canada's $155.5 million of 0% Accelerated Return Notes due Sept. 28, 2012 linked to the S&P 500.

The payout at maturity will be par plus triple any gain in the index, up to a maximum return of 14.55%. Investors are fully exposed to any index decline.

Also noteworthy was a large principal-protected deal - the fourth largest issue of the week - issued and sold by Bank of America Corp. It was $43.84 million of 0% Market Index Target-Term Securities due July 28, 2017 linked to the S&P 500 with an 85.5% cap.

Another big S&P 500-based deal brought to market and sold by Bank of America was a $46.73 million offering of 0% market-linked step-up notes due July 24, 2015. If the final index level is greater than or equal to the initial level, the payout at maturity will be par of $10 plus the greater of the index return and 33.8%. Investors have a 15% buffer.

Bank of America Merrill Lynch sold another large U.S. equity benchmark deal, RBC's $43.36 million of 0% Accelerated Return Notes due Sept. 28, 2012 linked to the Russell 2000. Resembling the top S&P 500 offering, this structure has a one-year tenor, a three-times leverage factor, no downside protection and a cap, which in this case is 21.48%.

The appetite for index products was also seen in the use of other structures, including autocallables.

The second top deal was an autocallable issue tied to the S&P 500. Bank of America Merrill Lynch sold $78.94 million of 0% Strategic Accelerated Redemption Securities due Aug. 6, 2012 linked to the index on behalf of Eksportfinans ASA.

The call premium is 9.6% per year if the index closes at or above its initial level on a quarterly observation date. There is a 5% buffer.

While the volume of equity index products stayed flat on a month-over-month basis, stock deals surged both on a weekly and monthly basis.

Stocks up

For the week, single-stock deal issuance nearly quadrupled to $511 million from $142 million. But the spike came after a week marked by a sudden collapse. The asset class accounted for a little bit less than a third of the total last week, compared with 26% the week before.

For the month, the asset class grew 29% to $1.1 billion.

Sources said that market conditions definitely helped.

"The jump in volatility created new opportunities for stocks," the sellsider said.

"Autocallables and reverse convertibles price well when volatility spikes," said Bronebakk.

Autocallables increased by almost five-fold to $165 million last week to make up 10.5% of the volume.

Reverse convertibles also recorded a strong recovery with $336 million sold in 113 deals, a 323% increase from the week before. They represented 21% of the market.

For the month, reverse convertibles, which suffered a lot earlier in July, saw their volume go up by nearly 5%.

Citigroup Funding Inc. priced the top reverse convertible deal and the sixth largest offering of the week: $39.13 million of 12% Equity LinKed Securities due Jan. 25, 2012 linked to Las Vegas Sands Corp. shares with a 20% buffer.

"In a higher-volatility environment, the coupon is higher because the premium you get from the put is higher," the structurer said.

Commodities strongly increased last week in volume, although the asset class declined in July compared to June.

Agents priced 15 deals last week totaling $134 million versus only one the prior week for $5 million.

The top commodities deal last week was Eksportfinans' $37.19 million of 0% Accelerated Return Notes due Sept. 28, 2012 linked to the Rogers International Commodity Index - Agriculture Excess Return via Bank of America Merrill Lynch. Investors will receive triple leveraged exposure to the underlying on the upside with a 15.6% cap and no buffer.

The top agent was Bank of America Merrill Lynch with $686 million sold in 23 deals for 43% of the total. It was followed by Morgan Stanley & Co. LLC and Barclays Capital Inc.

"In a distressed market, investors want to go to something they understand." - An equity derivatives structurer

"The jump in volatility created new opportunities for stocks." - A sellsider

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