Structured notes top $546 million for week, boosted by two big convertible deals; Fed rules eyed

By Emma Trincal

New York, July 1 – Last week’s tally of structured notes issuance was $546 million in 157 deals, lifted in part by two nearly identical synthetic convertible deals sized at $72.45 million each, according to preliminary data compiled by Prospect News. Part of the volume may also be the monthly calendar, which was likely to end last week as this current week only has two days left for June.

This half-a-billion figure is likely to be significantly revised upward: not all deals were filed with the Securities and Exchange Commission at press time.

The previous week saw the sale of $1.28 billion, according to updated data, a strong notional for the third week of the month, confirming what several sellsiders have noticed: distribution is more evenly spread out throughout the month.

Sell-off

The stock market did not do so well last week. Rising coronavirus cases across several states spoiled the hopes of a strong economic recovery. On Wednesday, New York, New Jersey and Connecticut imposed 14-day quarantines on travelers from several southern states including Arizona, Florida and Texas. Market sentiment shifted, pushing the S&P 500 index down 3% for the week.

The stock market has surged since the February-March timeframe, helped by a strong government stimulus and easing policies. But the pandemic remains a concern, and the resilience of the current bull market remains unknown.

The market had its best quarterly gain last quarter in more than 20 years. Meanwhile the economy is slowing down as a result of the Covid-19 pandemic.

Lockdown

“The stay-at-home has helped,” said a sellsider.

“The market keeps going up no matter what. More people die...no problem. The market is going up. Unemployment is climbing...Fine. Somehow this market is still going up. It’s crazy.”

He predicted a correction in the second half of the year.

“We know it’s going to happen. People believe that this bull run is going to last forever. I hear clients say they don’t need a buffer. The very next day, the market goes down.”

But the impact of a pullback on volume for the industry is unclear.

“It depends on how much the market goes down,” he said.

“If it’s a freefall, it’s not good for anyone. It’s there. You have a crash. People run for cover.

“But anytime there is uncertainty there is demand for structured notes. So, if we just have a minor correction, it could be good for the business.”

Lower swap margins

Two important regulatory events happened on Thursday.

First, the Federal Reserve System along with other agencies, including the FDIC, eased swap margin requirements for registered swap dealers. This decision was taken after the result of the Fed’s stress tests.

The new rule indicates that the Fed is concerned about the direction of the U.S. economy and the future bank earnings and capital, said Dick Bove, chief financial strategist at Odeon Capital.

“Those measures lower the capital requirements of banks by freeing funds. They then give the banks greater investment opportunities. They increase the ability of the banks to earn profits.

The swap rule is positive for banks, the sellsider said.

“It may also be favorable to issuers of structured notes especially the smaller ones, those who do less in volume.

“If you put less collateral on your swaps, it should increase your profitability.”

“Issuers may offer better terms. They also could take more profit. We don’t know. Competition may drive prices lower, but I doubt it,” the sellsider said.

Dividend caps

Separately, the Fed ordered the banks to suspend share buybacks and to cap the growth of their dividends.

Those changes were also announced after the release of the Fed’s stress tests.

While this measure is limited to bank stocks, the CARES Act of March already prohibits dividend payments by companies that benefit from the government loans offered in the context of the Act.

If the dividend restrictions gain momentum as a regulatory trend, more issuers may be negatively affected when pricing structured notes, said the sellsider.

“There is an impact on the hedges,” he said.

“When you buy a derivative, you are subject to certain rules when the dividend changes. The client is not doing derivatives contracts. They buy the notes. The terms are already set. But the bank has to price it. They buy the stock as a hedge based – among other things – on an estimate of dividend payments.

“If you structure a two-year note on a stock worth $100 and the dividend is $2, assuming it’s delta one and without considering any other input like interest rates and volatility, the cost of your note is going to be 96. Your hedge is based on that. If all of a sudden the company stops paying dividends, the bank is losing money.”

An extension of dividend restrictions may affect some structures more than others.

“The impact may be worse for autocallables because those are the deals linked to stocks,” he said.

Year, month

Volume for the year through June 26 remained robust. Agents priced $34.492 billion this year versus $22.261 billion last year, a 55% increase. The deal count is up 40% to 10,409 from 7,456.

“Honestly, I think we’re up because 2019 was such a terrible year. We’re just going back to normal,” the sellsider said.

“I do believe that people staying at home contributed to the rally and maybe to the rise in volume for structured products.

“People buy more financial assets because they’re at home. They have too much time on their hands. They look at their positions. They go online. The market is up. It’s also easier for advisers to reach you if you’re stuck at home.”

June through Friday is also strong although the month is not over yet. Sales amounted to $3.618 billion, a 16% increase from the same period last month, which saw the pricing of $3.118 billion.

Bank underliers

Autocallable notes with contingent coupon as always dominated the flow with 53% of the total in 132 deals.

The top deal in this category was Barclays Bank plc’s $38.3 million of three-year contingent income autocallable securities tied to Citigroup Inc.

The 10.75% annual coupon is based on a 50% coupon barrier and payable quarterly. The notes will be called on the quarterly determination date if the shares close at or above the initial share price.

The barrier at maturity is set at 50% of the initial price.

The agent is Morgan Stanley.

“This is a big deal on a stock,” said the sellsider.

Bank stocks have been popular underliers lately.

Bank of America Corp., JPMorgan Chase & Co., American International Group, Inc., Ally Financial Inc. and Citigroup Inc. were used on deals last week.

Financials are the second worst-performing sector this year after energy, according to Select SPDR website. It also has the most muted recovery over the second quarter, along with consumer staples.

“Maybe that’s why. There is volatility in the sector,” the sellsider said.

Leverage

Only five leveraged notes priced last week totaling $52 million with one much larger in size. It was Bank of Montreal’s $29.41 million of 13-month leveraged notes linked to the Russell 2000 index, paying par plus 3 times any index gain capped at 20.7% with a 1-to-1 downside exposure.

The agent is Wells Fargo Securities, LLC.

Some advisers, who used to like leverage in the past, seem to have lost interest. The overpriced market has given some pause.

“There are better deals out there than leverage,” said one of them.

“Leverage is what you do when you can’t think of a better way to get a return.

“But it’s a double-edge sword. You get the leverage. But your cap is low or your barrier is not protective enough. Sometimes it’s both.”

A tale of two Citi deals

For once, single stocks were the top asset class with $279 million in 108 deals. A little over half of that notional came from two synthetic convertible deals from Citigroup Global Markets Holdings Inc. Both deals priced at $72.45 million each and matured June 30, 2027. The first one is tied to Johnson & Johnson.

The payout at maturity will be the greater of par and par multiplied by (a) the final share price divided by (b) the threshold price, which is 118.9% of the initial price.

The second one, linked to the common stock of Kraft Heinz Co., has the same structure, but the threshold price is 131.2% of the initial price.

Citigroup Global Markets Inc. is the agent for both offerings.

“Those are institutional deals. I’m not sure why it’s being done. Maybe for accounting reasons instead of buying the stock directly. But it certainly doesn’t look like a retail deal. Structured products are not always retail by the way,” the sellsider said.

Tech issue

Another large stock deal was Credit Suisse AG, London Branch’s $33.46 million of three-year contingent income autocallables linked to the worst performing of Apple Inc., Alphabet Inc. and Microsoft Corp. The contingent coupon is 11.85%. Coupon barrier and downside threshold at maturity are 60%.

Morgan Stanley is the dealer.

High coupon on indexes

BofA Finance LLC priced $33.91 million of two-year callable contingent yield notes with daily coupon observation linked to the least performing of the Euro Stoxx 50 index, the Russell 2000 index and the S&P 500 index.

The quarterly contingent coupon is 13.3% per year based on a 65% barrier observed on every day that quarter.

The notes are callable at par of $10 plus any coupon due on any quarterly coupon payment date.

UBS Financial Services Inc. and BofA Securities, Inc. are the agents.

UBS and Morgan Stanley were the top agents last week pricing $121 million each. Morgan Stanley did it in eight deals and UBS in 116.

Citigroup Global Markets Holdings Inc. was the top issuer with $163 million in nine deals, or 30% of the total.

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