Volume steady at $423 million in an extraordinary week marked by volatility spike, euro fears

By Emma Trincal

New York, May 12 - Dealers priced $423 million last week as the market plunged on Thursday and volatility reached new highs, leading sources to believe that most market participants were caught off guard buying and selling products not necessarily tailored for a choppy market.

However, the nature of the deals and structures to be priced starting this week and over the next may change as the U.S. structured products market needs to adjust to new volatility moves, sources said. They predicted for instance more reverse convertible products and possibly fewer leveraged structures in this environment.

Ordinary volume

It was an ordinary first week of the month with U.S. structured products agents selling $423 million and 69 deals.

Compared to the first weeks of prior months this year though, where issuance is typically north of $500 million, volume was slightly weaker, according to data compiled by Prospect News.

When compared to the last week of April, last week's volume was down 75% from $1.83 billion, a total that does not take into account a $500 million exchange-traded note add-on Barclays Bank plc priced on April 28. But such changes are typical between the end of a month and the beginning of another, sources said.

More unusual was the overall market.

Last week was a turning point for U.S. structurers, sources said, with volatility levels doubling up amid fears a new credit crisis would threaten global markets and the U.S. recovery.

Three themes

Three themes emerged during the week, market participants noted.

First, investors were caught off guard when volatility surged on Thursday.

Second, deals expressing a bearish take on the euro finally priced, some of which were among the largest deals in size for the week, which was a change compared to the week before.

Finally, investors looked for exposure to Asia either through equity or a combination of bullish equity bets on Asia along with bearish currency bets on the dollar relative to Asian currencies, data from Prospect News shows.

The interpretation was that Asian exposure is ideal for investors who do not want to allocate to the United States and who need to flee the choppy European market, sources said.

Reverse convertibles missing

One sign that the volatility rally caught investors and issuers off guard was that deals that usually thrive in choppy markets did not price last week.

Issuance of reverse convertibles declined, for instance. They made up 9% of total volume with $38 million priced in 16 deals, compared with 31% of the total volume seen the week before, according to Prospect News.

Another type of deal popular when volatility is on the rise - autocallables - was not seen last week either.

On the other hand, leveraged deals, which tend to price more frequently when volatility is low as people seek faster returns, made for more than half of the volume, according to data compiled by Prospect News.

"With the increased volatility, products that short volatility will do extremely well, especially reverse convertibles," a New York sellsider said.

His explanation for the low supply of reverse convertibles deals last week was that the market took investors and issuers by surprise.

"The market collapsed on Thursday. No one was going to capitalize on the spike of volatility yet. You'll see a pick up of reverse convertibles this week."

He also predicted more autocallable structures coming up and for the same reason.

This sellsider explained that reverse convertible notes are popular among investors when volatility is up because investors in those deals are short volatility.

"The issuer who buys volatility from the investor hedges the cost by passing it on to the market," he said.

Barclays and Royal Bank of Canada, two issuers usually active in the sale of reverse convertibles, only sold five reverse convertible deals each last week.

Off guard

"The day volatility spiked up was Thursday. You can't just sell a publicly registered reverse convertible in one day. There's usually a two-week marketing period. Could someone have done a private deal on Friday? Yes, but you wouldn't know about it," said Michael Iver, previously structurer at JPMorgan.

Iver explained that there may be a short lapse of time before issuers come to market with more reverse convertible deals as volatility itself has shown sharp moves up and down over the past 10 days.

Volatile volatility

The CBOE Volatility index doubled to 40.95 on Friday from 20.19 on Monday. It was at 25 on Wednesday.

"Reverse convertibles are popular when volatility is on the rise. But there's a difference between volatility being high and stable versus volatility being volatile itself," Iver said.

"You may get a pick up of reverse convertibles, but don't expect it right away. Volatility is so volatile, deals don't get priced yet because you don't want to get killed."

Euro bears out

Currency deals represented 14% of total issuance, up from the week before when they amounted to only 4.5% of the volume, according to data compiled by Prospect News.

Sources noted that deals betting against the euro met investors' demand as fears around Greece's fiscal woes intensified.

"Everyone is worried about the euro. The bailout package has added more euros. People see further declines," said the sellsider.

"For a while the market was concerned about the dollar. Now people are running out of currencies to hide in. This is why gold is hitting new highs," he noted.

The euro has lost 11% versus the dollar this year.

Bank of America Corp. priced the biggest "euro-bear" deal and also the second largest of the week.

The bank offered $38.23 million of 0% Currency Market Index Target-Term Securities due May 30, 2012 based on the exchange rate of the Brazilian real relative to the euro.

There was also leverage as the payout at maturity will be par of $10.00 plus 2.37 times any gain in the real. The deal offered 95% principal protection.

The fourth-largest transaction was brought to market by Morgan Stanley, which offered another bearish bet against the euro.

It was an additional $30 million principal amount of 0% Market Vectors - Double Short Euro exchange-traded notes due April 30, 2020 linked to the Double Short Euro index.

Leverage factor

Leveraged deals took precedence amounting to 53% of the total issuance, according to data compiled by Prospect News.

For some, the trend was a sign that bulls were resilient or had not caught on yet with the market uncertainty.

"Investors like leverage when things are going in their favor. Maybe in the bull market up until last week, people were still enjoying a high level of confidence," the sellsider said.

"For bullish investors, the spike in volatility made pricing more in line with their risk tolerance," said a distributor.

"They can get higher coupons with more downside protection. For bulls that were not phased by the choppy equity market, last week's spike in volatility offered new opportunities," he added.

But for others, investors tend to favor leverage when volatility is low. As a result, the relevance of leveraged deals may decline if volatility continues to increase over the next few weeks.

"When volatility is high, leverage is expensive but the market is moving faster," said Iver, adding that the need for leverage may decrease.

"When volatility is low, leverage costs less and people want it since there's not much action," said Iver.

Impossible gold

The volatility momentum had another impact: commodity-linked deals decreased. They represented only 8% of the total issuance versus nearly 12% the week before. At the same time, demand for commodities remained high. Sources explained the mismatch as a result of higher pricing costs.

"The flavor of the week is this increased demand for gold. People want to get that exposure," said the distributor.

"But that option is getting more and more expensive, and so deals don't get done," he said.

Another hurdle against commodity-linked notes, this distributor said, was contango.

"Back a couple of years ago, commodity futures were not in contango. If you went further on the curve, it was cheaper to buy than on the spot. It has since changed," he said.

"If I had to buy a two-year oil futures contract today, it would cost me more than $76," he said.

The $76 figure refers to the price of the crude oil futures contract for June delivery.

However, Goldman, Sachs & Co. priced a large commodity deal, the sixth-largest of the week. It was a $26 million offering of floating-rate notes due May 24, 2011 linked to the S&P GSCI Industrial Metals Excess Return index on the behalf of AB Svensk Exportkredit.

The notes offered three-times leverage.

Flight to Asia

Investors sought exposure to Asia in a likely effort to reallocate their money away from European markets, sources said.

The third- and fifth-largest deals offered exposure to Asian stock indexes.

Barclays priced $31.13 million of 0% buffered return enhanced notes due May 26, 2011 linked to a basket of indexes and their related currencies.

The basket included the Hang Seng China Enterprises index with a 33% weight, the Korea Composite Stock Price Index 200 with a 24% weight, the MSCI Taiwan index with a 21% weight, the Hang Seng index with a 14% weight and the MSCI Singapore index with an 8% weight.

This deal also offered a bullish exposure to the currencies of those five Asian countries against the dollar with a two-times leverage factor and a 10% buffer.

Goldman Sachs Group, Inc. also offered Asian exposure with $27.04 million of 0% equity index-linked notes due Nov. 21, 2011 based on the Topix index, the fifth-largest offering of the week.

The notes priced at 100.85.

The payout at maturity will be par plus any index gain.

JPMorgan tops

JPMorgan topped the league tables pricing $135 million in 17 deals, almost 32% of the total volume.

The bank sold the biggest deal of the week with $41.7 million of 0% index knock-out notes due Nov. 15, 2011 based on the performance of the S&P 500 index.

Goldman Sachs was second with $82 million offered in nine deals for 19% of the issuance.

Merrill Lynch followed, capturing 10.5% of the market with $45 million sold in two deals.

"Everyone is worried about the euro." - A New York sellsider

"The flavor of the week is this increased demand for gold." - A distributor

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