Storm, pre-election slowdown, early cycle lead to tepid volume with sales down 77%

By Emma Trincal

New York, Nov. 7 - Hurricane Sandy, the pre-election pause and the early monthly cycle, were all combined factors that contributed to dampen last week's volume in the structured products market, down 77% to $312 million from the week before, according to data compiled by Prospect News.

Investors favored callable structures in the search of higher yields. For the year to date, volume continued to decline at an 18.5% rate, with sources blaming the low volatility for the most part.

The big difference between the week of Oct. 22-25, which saw the sale of $1.34 billion of products, and last week was easy to explain, sources said.

The first factor was the calendar.

"The last week of the month was the prior week. Deals get done before the last weekend of the month," said Michael Iver, founder of iVerit Consultancy and former structurer.

"The hurricane was no surprise. People were anticipating it. That's another reason why you had strong activity the week before," he added.

And then Hurricane Sandy hit the Northeast region of the United States on Monday.

"Put it this way: dealers in New York were trying to figure out how to get to work. People had more pressing issues, like power, food, family than structured products that week," said Iver.

"The storm had an impact. We ended up putting on our trades in Oct. 25, 26, the week before," said Andrew Valentine Pool, main trader at Regatta Research & Money Management.

For weeks and even months, sources have said that one factor behind the structured products slowdown was the elections wildcard. Now that it's over, many doubt that issuance will pick up much momentum.

Elections

"I don't think it will make a big difference in terms of volume," said Pool.

"For the market in general, regardless of your political preference, it's a positive because the elections bring some clarity. People will have a clearer picture of where to invest now that they know who the president is. It's a big step and it's a step toward more risk-taking."

This outcome could dictate the type of deals issuers may bring to market in the future, not necessarily the volume size, he said.

"Investors will take more aggressive positions in some areas because they now know who the president is. You could see people turning more directional, which would give issuers new opportunities if they become more dynamic and create more up-to-date investments," Pool added.

"Overall, I can see broker-dealers continuing to offer structured products because they're profitable.

"But on the investors' side, I'm more pessimistic. I see the volume falling somewhat," he said.

Just because political uncertainty is off the table does not mean structured products sales will regain strength, agreed Iver.

"I'm skeptical. At the end of the day, the determining factor is volatility. In the meantime, I would advise investors to buy insurance against their portfolio through the use of at-the-money put options," he said.

The top deals for last week were small relatively to the prior week. Only two exceeded the $20 million threshold versus 18 during the prior week.

The structural trend seen last week was a strong bid on callable reverse convertibles. Those products represented nearly 42% of the volume while traditional, non-callable reverse convertibles accounted for only 5.83% of the sales. The two largest offerings were callable reverse convertible deals as well as the No. 5 and No. 6 offerings.

Early exit

The top offering was brought to market by UBS AG, London Branch in its $32.72 million of 0% trigger phoenix autocallable optimization securities due Nov. 2, 2017 linked to the lesser performing shares of the iShares Russell 2000 index fund and the SPDR S&P 500 ETF trust.

If each fund closed at or above the 59.16% trigger level on any quarterly observation date, the notes would pay a contingent annualized coupon of 8% for that quarter. Otherwise, no coupon will be paid that quarter.

If each fund closed at or above its initial price on any quarterly observation date after one year, the notes would be called at par of $10 plus the contingent coupon.

In the absence of a call, the payout at maturity would be par plus the contingent coupon unless either fund finished below their trigger price, in which case the payout would be par plus the return of the worse performing fund.

For Pool, the potential liquidity is what makes a product such as this one popular.

"People like call features. If it gets called, you have money in your hands to buy something else. I can see why investors would like the potential for an early exit, especially in times of uncertainty like until yesterday when we didn't know who would be in office. People want fluidity. That's why these callable deals are popular," said Pool.

The other deal in this category - and the No. 2 in size for the week - was Morgan Stanley's $25 million of contingent income autocallable securities due Oct. 30, 2013 linked to the common stock of Coach, Inc., according to an FWP filing with the Securities and Exchange Commission.

The downside threshold was 70% of the initial price, observable quarterly with a contingent payment of 3.75%. Investors were fully exposed to losses if the stock fell below the threshold at maturity.

Low volatility

For Iver, the driving force behind the callable reverse convertible bid was the current low volatility environment.

"The unique motivation to invest in reverse convertibles is the coupon," said Iver.

"But volatility as measured by the VIX has come off from its high in June.

"When volatility is that low, the only way to offer attractive headline coupons is to sell additional optionality. In those deals, you're selling away the right for the issuer to take the coupon away from you.

"Because issuers have the right to call it, investors should not expect to earn this coupon for the life of the deal and this has an impact. Investors now have reinvestment risk, which may work in their favor or against them, it depends..."

Iver said that pricing challenges help explain not only the decline of regular reverse convertibles but also the lackluster volume seen so far.

Agents sold $30.47 billion as of last Friday, an 18.50% drop from $37.39 billion sold during the same period last year, according to the data.

Leverage versus coupon

For Iver, volatility is the main culprit, along with investors' unmet needs for yield.

"Current levels of volatility do not favor products that are short volatility," he said.

"I look at the drop in volatility from last year. The VIX in the late spring was averaging 22%. It is now at around 17%. Compare it to the last four months of 2011: the VIX is half that amount.

"If issuance year to date is off, it's indicative of a market preference for coupon rather than leverage. That's because with volatility so low, leverage is now cheap and single-name coupon deals have become more expensive. If the market really wanted leverage, you would see a strong increase in volume for those deals. Leverage should be increasing more than the coupon deals are decreasing. It's not the case," he said.

The data showed that all leveraged deals - excluding those with full downside protection - have not increased but decreased in volume year to date.

While they still dominate in market share, those leveraged products have seen their volume fall by 13% year over year to $10.94 billion.

Meanwhile, only callable reverse convertible deals have increased. This structure is up 110% and represents 11% of the total this year versus 4% last year. In comparison, low volatility levels have hit hard the regular, non-callable reverse convertibles business, down 67% from last year and accounting for only 5% of the year-to-date volume versus 13% last year.

Housing bulls

In terms of underlying trends seen last week, Morgan Stanley, with the No. 4 deal, used a noteworthy index, which has been popular in October.

Morgan Stanley priced $15.55 million trigger jump securities due Oct. 30, 2014 tied to the PHLX Housing Sector index.

This offering was the third one to use this index in October. During the same period, Bank of America priced two big deals tied to the PHLX Housing Sector index, one for $69.17 million on the behalf of Barclays Bank plc; the other was for $37 million for HSBC USA Inc.

The PHLX Housing Sector index is up 59% year to date.

"Housing is in recovery. It's so cheap to buy a house. Money is cheap. If you can get a mortgage for 4%, that's a big incentive. No wonder people are making bullish bets on the sector," said Pool.

"We've seen housing starts pick up recently. People are looking at targeted real estate plays, which would pay off ahead of an economic recovery. When housing recovers, people feel like spending money again. It's an early bet on economic growth," said Iver.

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