Volume down 47% for the month at $978 million; risk is out, full principal protection is in

By Emma Trincal

New York, Sept. 21 - Investors shied away from capital-at-risk products and sought full capital protection or partial protection, driving down volume as risk aversion and bearish sentiment prevailed over the search for higher returns.

Volume excluding exchange-traded notes last week rose by 62% to $485 million from $300 million the prior week, according to data compiled by Prospect News. But the prior week's volume had been particularly depressed.

On a month-to-month basis, September has yet to pick up. Volume was $978 million for the first half of September, a 47% decrease from the $1.84 billion issued during the same period of August.

"August was a lot busier than September," a sellsider said.

"When August started to get bad, it was an opportunity to get in and buy autocallables and reverse convertibles.

"Since the market has continued to fall, people are getting worried.

"Pricing conditions look better, but people are reluctant to buy, and it drags down volume overall."

So far this year, however, sales have grown by 14.48% to $31.41 billion from $27.42 billion this time last year.

One sign of risk aversion was the strong interest in fully protected notes combined with the continued decline in reverse convertibles, which are among the riskiest structures, sources said.

Full protection

Agents last week sold more 100% principal-protected leveraged notes than usual.

Those deals jumped in volume to $33 million from $2 million the week before, and their market share as a percentage of total issuance rose to 7% from less than 1%.

Leveraged notes offering full principal protection rose to $35 million so far this month from $1 million at the same time last month, showing that the bulk of the trend occurred last week.

"It's the worst pricing environment for principal-protected products: interest rates are low, volatility is high. But I can understand why people buy them," the sellsider said.

"Terms aren't great because the zero-coupon [bond] is expensive due to the low interest rates and buying the call option is expensive too because volatility is high.

"But if you have to get into the market, what choice do you have? People are scared. You still have to put your money somewhere. If you stay on the sidelines and the market rallies from there, what do you do?

"I suppose it's very difficult to be a financial adviser right now," he said.

A structurer agreed, explaining that low interest rates leave issuers with very little financing available to buy the call options or call spreads necessary to give investors some upside.

"You can buy less options," he said.

"Capital-protected products are not easy to build right now. Issuers end up extending the duration or they offer less upside.

"Still, people out there are very risk averse. They'd rather have smaller returns and not lose any principal."

The top full-principal-protection deal and the second largest offering for the week was Bank of America Corp.'s $33.46 million of 0% Market Index Target Term Securities linked to the Dow Jones industrial average. The structure offers par plus 133% of the index return, with investors getting at least par.

Picking the risk

The structurer said that some issuers are in a better position to offer better terms than others when they have more funding.

"A bank with less creditworthiness benefits from better funding and can buy more calls or increase participation," he said.

He gave the example of Bank of America, which saw on Wednesday its long-term senior debt cut to Baa1 by Moody's Investors Service.

"Bank of America has a relatively high credit risk, and their funding needs are quite high," he said.

"They have two solutions. They can issue bonds or they can fund themselves through their treasury by issuing products.

"With the 2016 Bank of America bonds yielding at 5.7% per annum, they have a lot more interest rate at their disposal to buy calls.

"They can issue a zero at 5% and package it with call options on the Dow Jones for instance, and it would cost them much less than issuing a bond.

"Investors get a much better yield than the 1.5% risk-free rate.

"The idea is that a bank with higher credit risk has to pay higher interest rates to issue a bond. Since they'd have to pay this higher interest rate anyway, they can issue more attractive notes.

"It doesn't mean the product is going to be better if you compare it to those issued by better-rated banks, like JPMorgan. But it's optically better."

Just because a deal looks good doesn't mean it is, the sellsider said.

"If you're going to buy full principal protection because you're worried about the market risk, then don't go and take on more credit risk. It makes no sense," he said.

"Buying those products from the bank with the widest credit rating out there does have some risk, doesn't it?"

He said that Bank of America's five-year credit default swap spreads are now more than 500 basis points.

"I'm not suggesting that Bank of America is going to go bust. But if you want protection, think credit risk and buy those notes from a less risky issuer," he said.

Credit risk and market risk have become closely tied issues in the mind of investors, the sellsider added.

"I think you're seeing less volume because any structured product has credit risk behind it," he said.

"And right now, people are more reluctant to buy because they're more worried about bank risk. It's true in Europe, and it's true in the U.S."

Buffered notes

Investors tried to avoid risk last week by buying leveraged notes with partial downside protection as well, using buffers or barriers.

The trend was more visible last week - those products rose to $92 million from $34 million - than for the month. Compared to the same period in August, the volume of this type of product in September is down 58%.

The top leveraged buffered deal and the No. 1 offering for the week was Bank of America's $33.75 million of 0% Capped Leveraged Index Return Notes due Aug. 30, 2013 linked to the S&P 500 index with two times leverage, a 34.86% cap and a 10% buffer.

Reverse convertibles

Risk aversion was also noticeable in the continued decline of reverse convertible issuance.

While the volume for those deals, which are short volatility, rose last week to $55 million from $21 million, it fell 40% for the month.

Sources said that overall, the issuance of such products has been slow since the beginning of summer.

The structurer said that perhaps investors need to be better educated on the risk/reward profile of these notes, which are bought at less attractive terms when volatility is down and avoided when pricing becomes more attractive.

"With a reverse convertible, you get a higher coupon when the underlying volatility is high," the structurer said.

"Yet, investors tend to buy them when their volatility is low even if it means lower coupons.

"They get a 20% buffer and a 5% coupon, and they think they're taking on less risk.

"What they don't see is that the market can turn. They get knocked out when the market turns south."

In theory, the sales of reverse convertibles should be dictated by pricing conditions, and you should see more of those in today's market as higher premiums compensate investors for the downside risk, he said.

"But in reality people are scared. These are tough products to sell. I don't get much volume either because the risk appetite has diminished," he said.

The volume of equity-linked notes has declined by more than half so far this month to $635 million from $1.46 billion, which represented a decline to 65% of the volume from 79% month to month.

All asset classes have declined, including stocks, equity indexes and commodities.

Commodities, however, held on best, declining by 11.5% to $121 million from $137 million month to month.

Bank of America Merrill Lynch was the top agent last week with nearly 50% of the volume at $324 million.

It was followed by UBS and Barclays.

"August was a lot busier than September." - A sellsider

"Capital-protected products are not easy to build right now." - A structurer

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