Outlook 2023: Past year’s structured notes tally not so bad after all; stronger sales anticipated

By Emma Trincal

New York, Dec. 30 – Sales of structured notes finished the year weaker than in 2021, but it could have been much worse, market participants said. They remained relatively confident for 2023.

Agents sold $82 billion in 2022 through the end of November versus $92 billion in the previous year, a nearly 11% decline, according to data compiled by Prospect News.

“2022 has been a difficult year for investors and issuers alike. Notes issued earlier did not get called. Money didn’t get reinvested. And with the market declining, investors have been staying on the sidelines,” said Shilpa Akella, managing director, head of equities structuring Americas at Barclays.

However, the past year may not be as bad as the data suggests. It followed 2021’s all-time record of over $100 billion, which set a high bar. Moreover, figures at press time were still preliminary and subject to upward revisions. Finally, with more filings to come throughout December, some predicted that the year’s total notional volume may actually be flat or even perhaps higher.

“Even with headline numbers not that glamorous, we had a really, really strong year,” said Brady Beals, director, sales and product origination at Luma Financial Technologies.

“With all the obstacles we had in 2022 – a weak equity market, the Fed’s aggressive rate hikes and a top issuer out of the market for months, to think that we may finish the year slightly negative and perhaps flat, that just tells me that a lot of new notional came in.”

Other distributors and sellsiders who shared this view made bold calls for the upcoming year.

“I believe there are a lot of catalysts in our market that could make 2023 another great year,” said Andrew Kuefler, senior vice-president, iCapital Solutions, pointing to the growth of technology platforms, which bring larger pools of capital and encourage new advisers to adopt the product.

“So, if you asked me, I would say that we’ll see more than $100 billion in the upcoming year.”

The year ahead

The market turmoil set the stage for better pricing and demand for customized products, said a structurer who is also upbeat about the months ahead.

“It’s hard to tell how much volume we will get. But the outlook is good,” he said.

“Rates are high, volatility is high. It’s a goldilocks moment for structured notes, and it’s been like that throughout the year.”

If the markets remain volatile in 2023, more investors will flock to structured notes for the higher coupons and downside protection, he said.

Investors may have faced market and macroeconomic headwinds in the past year. But structured notes are designed to offer “solutions” to those problems, he noted. As a result, the relatively lighter flows in 2021 almost came as a surprise to him.

“The industry should have had a better year,” he said.

“To me, the primary reason for the drop in issuance was not market-related. It was Barclays.”

Missing player

In March, Barclays Bank plc – the top U.S. issuer in 2021 – realized it had erroneously over-issued structured notes for a total amount of $14.8 billion between July 2, 2019 and March 10, 2022 along with $2.8 billion of exchange-traded notes. Issuing in excess of the registration shelf was a violation of U.S. securities laws.

The bank stepped out of the market for about five months, which put the brakes on the overall issuance volume for the rest of the year. Aside from having to pay a fine to the SEC, Barclays had to make a rescission offer to holders of the over-issued securities. The bank filed its offer on Aug. 1, a day prior to reentering the market.

“This error took Barclays off their platform for a good chunk of the year. It was bad news for the structured products market,” said a buysider.

Yet the rescission ended up being a “good story.”

In September, initial investors in the over-issued notes who had accepted Barclays ‘offer and whose claims were validated received from the bank a total of $7.7 billion via the Depository Trust Co., according to a company’s announcement. Barclays did not disclose the amount paid to the claimants who were holders but not initial investors. Such proceeds were to be released via the broker or the bank where the notes were held, according to the rescission filing. Therefore, it is not clear how much of the remaining over-issued securities was effectively returned to the market and reinvested.

Making them whole

But in most cases, the rescission had the positive effect of a “bailout” for investors whose trades were under water.

“A lot of the proceeds from the rescinded securities were reinvested. Investors in most cases were made whole and received par,” a market participant said.

In the meantime, the pricing conditions had changed for the best.

“With Barclays’ paper, we did tender, and we flipped into new notes with better terms,” the buysider said.

“From coupons paying 4% to 6% we ended up being able to get fairly better offerings even though we had to pay the coupon back. We stepped into double-digit-coupon notes.”

While it’s tempting to attribute last year’s weaker issuance to Barclays’ temporary exit, it is not the main factor, said the market participant.

“It was more a function of the market’s behavior. Yes, Barclays was out from March to July. But the structured products market is extremely competitive. Other issuers stepped in, producing more. Others gained market shares such as Morgan Stanley and the Canadians.

“Meanwhile, a lot of Barclays’ lost market shares were offset by the rescission.”

The data seemed to validate the point.

The rescission closed on Sept. 12. The bulk of Barclays’ proceeds was released during that month, which turned out to be the best month on record for structured products issuance, according to data compiled by Prospect News going back to 2004.

Bond competition

The Fed’s tightening, soaring inflation and fears of a global recession spooked investors last year. The market entered into bear territory, but a few sporadic rallies made it look more like a roller-coaster. The trend however was bearish with the S&P 500 index down 27.5% from its January peak to a bottom in mid-October.

But a negative stock market does not systematically crush demand for structured notes.

“Volatility can help the pricing of some products, but too much volatility scares investors and pushes them to look for safe assets in cash and Treasuries away from structured notes,” said Barclays ’Akella.

“In the same fashion, higher interest rates can be beneficial for the pricing of some notes, especially principal-protected notes. But rising interest rates could have an adverse impact if the yields of traditional bonds compete too much with structured notes coupons.”

Interest rates climbing was a concern for some advisers. For several years now, investors have piled up on autocallables in order to secure yield in a zero-interest rates environment. When risk-free interest rates rise, structured notes become less attractive.

“I think higher rates are going to be an obstacle. How much of a risk are you willing to take when you can get some pretty good yields in the fixed-income space or even with money markets?” a financial adviser said.

“I don’t know if we’ve ever had a robust structured notes market in a high interest rates environment. That just never happened. When Treasuries yield 1.5% you will consider buying structured notes. When you can almost get 5% from government bonds, I’m not so sure.”

Flight to quality

But others believe that the risk of bond yields rising further is overdone. Equity bears in particular rule out the possibility.

“The first half of 2023 will likely experience significant losses for stocks worldwide,” said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

With U.S. Treasuries of three-year to maturity and shorter showing yields not seen since July-August 2007, assets from stocks and real estate will likely shift into Treasuries as it happened after 2000 and 2007, he predicted.

“I expect U.S. Treasury yields to drop significantly during the next several months across the yield curve.”

But equity derivatives may be insulated from the threat of traditional fixed-income.

Even if bond yields remain elevated for some time, demand for autocallables should not be impacted, said Vinit Srivastava, co-founder and chief executive officer of index provider MerQube.

“Income notes remain attractive given the state of the market,” he said.

“Treasuries may have gone up above 4.5% but if you can get 7% to 10% on an autocall, it’s a no-brainer. Structured notes remain very competitive.”

No calls

The real consensus among market participants about what put the brakes on structured notes sales in 2022 could be expressed in two words: “no calls.”

“With the significant drawdown in global equity markets, one headwind the market faced this year was dramatic drop in call frequency of auto-callable yield notes, which had been an extremely popular product and source of reinvestment funds over the course of the last few years,” said iCapital’s Kuefler.

“That velocity of money slowing down was definitely felt across the marketplace.”

Autocallable issuance, including Phoenix autocalls and snowballs, dropped more than 40% this past year compared to 2021.

While those products accounted for two-thirds of the pie in 2021, they represented less than half of it last year.

The decline in calls impacted the overall deal count, which fell by approximately one third last year.

“No wonder business was down since that repatriation of products didn’t happen,” said the buysider.

One way to measure the impact of the “no-call” factor on issuance volume is the “recapture” rate, which is the quotient of reinvested assets (at maturity or upon a call) divided by the total amount of sales.

Such rate does not exist for the overall market. But firms know their own. This buysider for instance said his recapture rate is at around 65%. But some wirehouses have much higher rates in the 80% to 90% range, he noted.

New money in

Firms with a lower recapture rate may have a competitive advantage when call frequency declines.

“Our trading volume was up 25% in 2022. We had a huge year even though most of our notes didn’t get called,” this buysider said.

“Our example shows how resilient the structured products industry really is. Even though we didn’t have a lot of rollovers, there was actually a lot of new money coming in.

“From that perspective, 2022 was an excellent year.”

While high recapture rates have a positive boomerang effect in a bull market (a main driver behind the strong volume in 2021), they have an adverse impact in a bear market.

“If the market rallies a bit, the increased callability will bring money back to the market, which would help issuance volume,” said Akella.

A blend of products

If autocall sales weakened last year, other structures gained traction. Leveraged notes and digital products for example made a comeback.

In 2021, explained a sellsider, autocalls were the largest share of the market driven by economic conditions as the rates were at zero. Extra low rates also squeezed the terms of growth notes as issuers could not price principal protection.

“Now we’re back to a more normal mix between growth and income, which is more in line with historical patterns,” he said.

“We see the trend back to pre-pandemic trends,” he said.

Higher funding rates will push some products to the forefront, said Luma’s Beals.

“We’ll see more digitals and principal-protected notes, which are positively impacted by more funding,” he said.

Funding rates also drive issuers’ decisions, he explained.

“When rates were low, it made sense for issuers to do callable structures. But now that funding rates are higher, why calling back when funding is more expensive?”

More growth products will emerge for the same reason, he said.

“Growth notes are more funding-driven than income notes. It may be even more the case with uncapped digitals,” he said.

Bullish buyers of structured notes often complain about caps. They seek growth with uncapped upside. One way to match their requests over relatively short tenors has been the creation of participation notes with a one-time call, usually at the end of the first year.

“This structure, which emerged in 2021, should continue to draw people’s attention,” said Akella.

Digitals gained significant traction in the past year. The trend should persist, sources said. One overlooked factor behind their increased popularity is their tax treatment, said Beals.

“The digital has gained a bigger share than it traditionally had. You’re still getting the same coupon as an autocall. But for tax purposes, that’s capital gains, not ordinary income. This kind of favorable tax treatment is resonating with folks. People are becoming more sophisticated, more familiar with the product.”

Last year saw the return of principal-protected notes.

“The possibility of a recession has made those products more popular. They’re pricing better too because rates are higher,” said MerQube’s Srivastava.

Indexes’ reign

Issuance of single-stock-linked notes plummeted last year, down 46% through the end of November compared to 2021. The trend contrasted with their explosive growth in the previous year.

“What sells are big growth names with high options volume, essentially big tech,” said Srivastava.

“The drawdown seen this year with tech stocks has been significant. In a typical risk-off fashion, people have exited those trades and moved toward indices.”

If volatility increases, the shift from single stocks to indexes should persist in the coming year, Akella said.

The flight to safety could also be a quest for simplicity.

“Worst-of issuance should decline as well because investors won’t need to take that kind of esoteric risk if they can get decent terms on single indexes,” Akella said.

© 2015 Prospect News.
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