August gets off to good start with $533 million volume, a 133% increase; buffers make comeback

By Emma Trincal

New York, Aug. 13 – August began on a stronger note than July with 130 deals totaling $533 million for the week ended Aug. 8, a 133% increase from last month, according to data compiled by Prospect News.

It is too soon to assess August, sources said, because the month is still young and July began with the Fourth of July holiday.

On a year-to-date basis, however, the market recorded a 15% advance in volume from last year. Agents have priced $25.92 billion this year versus $22.58 billion during the same time in 2013, the data showed.

Last week included a larger deal in excess of $100 million distributed by Raymond James. The top structures in size were mostly leveraged notes with a high proportion of buffers, which speaks to the ability of firms to circumvent the negative pricing effect of the bull market.

Smaller in size, autocallable reverse convertibles remained the best-selling structure with a third of the total volume.

Big energy deal

The largest deal priced on Friday. It was Bank of Montreal’s $101.01 million of 0% “New U.S. Energy Paradigm” notes due Aug. 19, 2015 linked to a basket of 20 energy stocks selected by Raymond James’ equity research department. The issue price was 102.75. Investors will receive the return of the basket minus a 0.25% redemption charge. Raymond James distributed the deal.

The size of the issue for a delta-one product surprised a few.

“It’s a pretty large deal. If it’s distributed by Raymond James, I wouldn’t see it. It must be some strategy that they’re employing which is supposed to be better than an ETF or an ETN by concentrating on some holdings picked by Raymond James analysts,” said Andrew Valentine Pool, main trader at Regatta Research & Money Management.

The stocks composing the basket were indeed picked by Raymond James, which has a bullish outlook on the energy sector, according to the prospectus.

“An argument can be made that a client would do better with energy stocks selected by Raymond James than if they used a closely related ETF. If you wanted to reproduce the basket yourself, the cost would be prohibitive,” added Pool.

“But to sell it at a 102.75% premium seems like a lot.”

The energy sector has outperformed the S&P 500 index so far this year, sources noted, with geopolitical tensions in the Middle East and in Ukraine acting as a catalyst.

The Energy Select Sector SPDR ETF is up 8% year to date versus 5.25% for the S&P 500.

Baskets

Issuers have also increasingly been using baskets for the structuring of deals, the sources noted.

“A basket note is inexpensive to structure,” a sellsider said.

“In addition, dividends are not redistributed, which gives the issuer more room to play. But this note has no optionality. I’m not sure whether the use of dividends goes into the pockets of the investors or perhaps it does in the form of alpha, but it certainly provides the distributor with a nice fee.

“We see more use of baskets in general. When the constituents are indexes, issuers tend to choose indexes that have little or no correlation. For instance you might use the S&P with the Nasdaq if you want less correlation because you’re talking tech and blue chip. You may also see the Russell with the S&P, and here again, correlation is lower since you’re dealing with large cap and small cap.”

Creative buffers

Another trend seen last week was the prevalent use of buffers on the largest deals.

Six among the top 15 offerings offered some downside protection. Five of those deals used a buffer and the sixth used a barrier. Sources explained that demand remains strong from investors, who tend to be worried about high valuation levels in the U.S. equities market, but pricing is still not there, leading banks to use “creative solutions” to offer some limited downside protection.

“You need to sell volatility to put those buffers in place, and right now there is not enough vol,” the sellsider said.

“Issuers have to find ways to cheapen the options. They have to be creative. They use different structures like worst of or range accruals. They can also make the deals longer or introduce some leverage on the downside. There are a variety of ways to do that.”

The third largest deal offered an example with the issuer combining a longer tenor with a geared buffer.

Credit Suisse AG, London Branch priced $31.6 million of 0% Buffered Accelerated Return Equity Securities due Feb. 8, 2019 linked to the S&P 500 index with a 110.9% upside participation rate and a 35% buffer. Investors will lose 1.1538% for every 1% decline in the index beyond 35%.

Another strategy consisted of offering underlying indexes with more pricing power than the S&P 500. The Euro Stoxx 50 with its 3% dividend yield and recent volatility pickup has been used a lot as it enables firms to offer better terms, according to sources.

The No. 4 deal, Goldman Sachs Group, Inc.’s $19.32 million of 0% buffered notes due Aug. 9, 2016 linked to the Euro Stoxx 50 index, combined the use of the Euro Stoxx with a geared buffer to put together a shorter-dated leveraged buffered note.

The notes offer a 32% cap on a two-year term with a 15% buffer. The downside leverage is 1.1765 times the decline beyond the 15% buffer.

“Volatility has increased in the European stock market,” a market participant said.

“Since its peak in June to four days ago, the Euro Stoxx 50 has seen a 10% correction.

“The sanctions imposed on Russia have had a negative economic impact on the euro zone. It has put a drag on exports and growth. As a result, volatility has picked up in Europe, which explains why the use of the Euro Stoxx is so widespread. Issuers are able to show better terms, including better buffers.”

Things are slightly different in the U.S. market where volatility is still significantly low, sources said.

“Volatility shot up in the beginning of the month and went way back down. People are expecting the market to do well, and it’s at times like this that you want to have protection,” said Pool.

While the number of geared buffers has multiplied, Pool said that he still stays away from this type of downside protection.

“I’m not a fan of that,” he said.

“Depending on what the client hires the manager for, say it’s a 20% buffer, it still helps that the first 20% are protected, but after that, the losses become greater, and we don’t like that. Our clients would not like that.”

Autocallables

In both volume and number of deals, autocallable reverse convertibles remained the dominant structure last week.

Agents sold $176 million of them in 59 offerings, or nearly 32% of the total volume last week. For the year, this structure type is about a quarter of the total volume with $5.80 billion, a 13% increase from last year, according to the data.

The success of this product is the result of issuers’ effort to counter the negative impact of low volatility, explained the market participant.

“You get a nice headline coupon, and if you structure it right, you give the investor a fair chance of getting the coupon,” he said.

“Coupons on autocallable reverse convertibles are higher than in a traditional reverse convertible because of two unknowns. The first unknown is your maturity. You don’t know how long the deal is going to be since it can be called. It’s more risk, and you get paid more for this. The other unknown is the coupon. If you put the coupon at risk like you do with a contingent coupon, you also get a higher rate.

“When compared to a traditional reverse convertible, an autocallable reverse convertible with a barrier can pay double the coupon.”

Nearly all of the autocallable reverse convertibles were structured around a single stock, the data showed. In some cases, however, the issuer employed equity indexes.

“If you throw in there a worst of, you can substantially increase the coupon even with the less volatile indexes because you introduce the correlation factor,” the sellsider said.

An example was last week’s No. 2 deal. JPMorgan Chase & Co. priced $50.13 million of contingent coupon callable yield notes due Aug. 10, 2018 linked to the least performing of the S&P 500 index, the Russell 2000 index and the iShares MSCI EAFE ETF. The notes pay a quarterly coupon at an annualized rate of 7.5% if each underlying component closes at or above its 60% barrier level on the observation date for that quarter.

The notes are callable at par plus the contingent coupon, if any, on any interest payment date other than the final date.

The payout at maturity will be par unless any underlier finishes below its 60% barrier level, in which case investors will receive par plus the return of the worst-performing underlier.

Resilient market

In the face of poor pricing conditions with low interest rates and low volatility making the deals more difficult to structure, the U.S. structured products market has showed a strong resiliency, sources said, growing 15% in volume from last year.

“I have to say, I’m surprised,” said Pool.

“I would have expected volume to be flat because of the rally. We had a bull run even if it has been a choppy bull run.

“We like structured products a lot for the return enhancement. We figured this year would be flat since we had such a great 2013.

“So far the S&P is up a little bit more than we expected, but clients are doing just as well as long as they don’t reach their caps. Take a 14% cap with two-times leverage and we’re not there yet. The market would have to be up by 7%.”

Equity frenzy

The sellsider also expressed surprise. With the market so “richly valued,” he would have expected investors to demand more buffers and show more caution.

“Why is it up from last year? I’m not sure. Equities are the big thing. You probably have more equities notes this year than last year. Retail is unbelievably bullish. People use two or three times leverage with less and less downside protection. It’s a fixation on equity,” he said.

Equity-linked notes, including single stocks, ETFs, stock baskets and equity indexes, made for 82.65% of total volume this year versus 78.60% last year, according to the data.

Volume in this asset class rose to $21.43 billion from $17.74 billion, a 21% increase from 2013.

Bearish notes

“One interesting thing I’ve noticed though is a couple of bear notes in the last couple of weeks,” the sellsider said.

“I was surprised, but I think it’s a good sign. I expect a 10% to 15% correction by the end of the year. I am not the only one. But people don’t seem to be in a hurry to hedge. Maybe we’ll see more of those bear notes.”

HSBC USA Inc. priced $12.28 million of 0% bear Strategic Accelerated Redemption Securities due Aug. 28, 2015 linked to the Russell 2000 last Thursday. BofA Merrill Lynch was the underwriter.

If the index closes at or below the initial index level on a quarterly observation date, the notes will be called and investors will receive an annualized call return of 11.6%.

If the notes are not called, investors will lose an amount equal to the index gain.

Separately, UBS AG, London Branch was set to price 0% bearish contingent participation autocallable optimization securities due Aug. 24, 2015 linked to corn futures contracts on Monday.

One factor behind the growth may be the result of the popularity of autocallables, said the market participant.

“Autocallables have become the No. 1 structure. You’ll get more calls, especially in a bull market, so the deals get called, you have to roll them over. It’s a shorter maturity, so it happens more often. This is one big driver behind volume growth. And of course, the banks get to pocket more fees,” he said.

With the pricing of 33 offering totaling $126 million, JPMorgan topped the week with 22.85% of the volume. It was followed by BMO Capital Markets, which sold 18.75% of the total.

“When compared to a traditional reverse convertible, an autocallable reverse convertible with a barrier can pay double the coupon.” – A market participant

“Retail is unbelievably bullish. ... It’s a fixation on equity.” – A sellsider

© 2015 Prospect News.
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