Outlook 2018: Structured products issuance volume may continue to grow, albeit at a slower pace

By Emma Trincal

New York, Dec. 29 – The past year was the best one since the financial crisis for U.S. structured products with sales buoyed by a robust bull market. Many believe it can’t happen again this coming year. Others defy the skeptics, betting that 2018 could be another good year for U.S. structured products, perhaps even a better one.

The resilience of the bull market will be the test.

An exceptional year

Agents sold $47.71 billion of structured products in the past year, a 30% jump from the same period the year before through Dec. 21, according to data compiled by Prospect News at press time. The full month of December had not been accounted for and it’s unlikely that 2017 could top the 2008 record of $50.52 billion. But it is now certain that the year was the second best.

The market rallied, boosted by hopes around the passing of U.S. tax reform, which the Congress voted at the last hour just before Christmas. The benchmarks hit successive all-time highs throughout the year. Short of the last trading week of December, the S&P 500 index was up 20% for the year.

The surprising vigor of the aging bull market, which sellsiders credit for most of issuance’s robust growth, surprised almost everyone both in the industry and on the Street.

“Last year, I predicted an approximate 15% growth in the size of the market, given concerns about how the [Department of Labor] regulations would impact the fee-based business – but it turned out that 2017 was twice the performance of my prediction,” said Keith Styrcula, chairman of the Structured Products Association.

“For 2018, I continue to be conservative in my forecast for the coming year – 12% to 15% – but that could underestimate the potential growth to be created by the technology platforms. It will be a watershed year for notes, if the technology takes off.”

Good momentum

Robert Sowinski, managing director, head of structured products at Advisors Asset Management, shows some optimism as well, although a more conservative call.

“We have good momentum,” said Sowinski.

“We’re definitely seeing new advisers seeking a new opportunity with structured products.

“I think the issuance volume should be growing slowly and steadily next year. We should be up between 5% and 10%.

Even if the bull market turns mild, volume could still be on the rise, according to a structurer.

“We’re not necessarily going to have a crash, although a 10% normal correction is likely. But equity gains will be low. This should be very good for income notes. I can see a 20% increase in volume as a result,” he said.

The bull did it

Although structured notes have this reputation of being market “agnostic,” it’s nearly impossible to make predictions without taking into accounts key indicators, such as volatility, rates and correlations.

“Issuance has increased this past year for two reasons – the market was up, sentiment was bullish, that’s one. Second, rates remained unexpectedly low, driving flows into income deals, with the majority of this in autocalls,” said Sam Rosenberg, managing director with financial services firm Olden Lane.

“Sentiment is positive. People want to put more money in the market. Banks issue more autocalls.”

Issuance of autocallable notes, the top structure of the year with over 40% of the total sales, has been a godsend, sources said.

“In a rising market environment, when you have a lot of volume in autocalls, a majority of those products is being called and typically it gets rolled,” said Rosenberg.

Market, tech factors

Rosenberg believes that the exceptional bull run of the past year is not likely to be as strong.

One factor of sluggishness that played out in 2017 will be removed, he noted, citing the unchartered territory around the implementation of the DOL fiduciary rule, which was finally postponed to July 2019 for the full application.

“Now obviously the big unknowns are market conditions,” he said.

Rosenberg expects more turbulence in 2018.

“We’ll see more volatility and it will slightly reduce the notional amount. I say ‘slightly’ simply because the market won’t be as favorable.

“So I see volume flat to slightly down,” he said.

Some are more optimistic.

“My prediction is at least another $10 billion for this coming year if you add unregistered paper, what the French banks are doing,” said Matt Rosenberg, sales trader at Halo Investing.

His company is a technology platform that offers online distribution of structured products.

For him, volume relies a lot more than before on automation.

Volatility wildcard

Strong stock gains combined with record low volatility was a good combination for the industry, said Olden Lane’s Rosenberg.

Higher volatility is conducive to better pricing in structured products, and the industry lacked this advantage. But its net benefit is to keep investors confident.

“You want a little bit more volatility to offer better terms. But if you have too much of it, people get scared,” he said.

So how much is too much?

“It would be great if the VIX gently rose and stayed around 11. But I see mostly spikes in the 14 to 18 range,” he said.

The CBOE VIX index has been hovering around 10 for most of the year, except in April and August when it traded near 15.

Rosenberg however is not bearish.

“The equity markets will experience stress but not dislocation,” he predicted.

Best of the worst

Record low volatility has made manufacturers more creative.

Financial engineers always come up with new tools when some of the usual ones are in short supply, a structurer said.

And indeed, one of the biggest trends of the past year has been the successful attempt at finding a remedy against plummeting volatility levels. It translated into using correlation risk as way to offset the low premium extracted from products that are short volatility, which are income-oriented deals.

This was done by introducing more than one underlying in the product and linking the return to the lesser-performing asset. This resulted in an explosion of worst-of deals filling the need for yield.

“Worst-of have been the most popular structure,” said Sowinski. It’s been very popular among advisers and investors. In a low volatile market, by adding a worst-of option you can keep up with some level of return,” he said.

Olden Lane’s Rosenberg explained why worst-of deals were so highly sought after.

“Everybody wants income, and you can’t get it through CDs. You need some equity risk,” he said.

“But volatility has been low as well. As a result, traditional reverse convertibles produced coupons with little appeal.”

Correlation trade

One could argue that volatility has been low for several years. Why did worst-of issuance peak last year in particular? That’s because correlations fell to historic lows last year, said Rosenberg unlike the year before.

Dislocations between asset prices in a bull market are not uncommon. But the trend was exceptionally notable last year.

“Correlations dropped a lot last year, offering a good opportunity for worst-of issuance. That was a huge incentive to issue worst-of,” he said.

With worst-of options, the premium increases with risk. Little or negative correlations between the underliers increase the risk of breaching the downside barrier, hence the possibility to boost coupon payments.

Ever since the presidential election of president Donald Trump in November 2016, sectors started to drift apart based on expectations about how the new economic policies will impact a sector versus another. This too added more dislocations between stocks and sectors making the economics of worst-of deals even more relevant, he said.

“We’ve seen a great deal of sector rotation, and it has lowered the correlations even more,” said Olden Lane’s Rosenberg.

Sectors with low or negative correlation will be used in worst-of deals linked to sector-based exchange-traded funds, he predicted. Some recent pairs have been health care and technology; technology and consumer; and consumer added to banking.

Indexes to stay

There could be more worst-of deals in the upcoming year although it will depend on the respective evolution of volatility and correlations.

“We’ll see worst-of. It’s not going to change because correlations will remain low,” Rosenberg said.

“But volatility will come back. I can’t imagine volatility staying as low as it is today.”

Low correlation but higher volatility could in theory pave the way for more single-stock deals.

“You could make the argument that we will go back to reverse convertibles,” he said.

But he would not necessarily make that call.

Sowinski is also skeptical.

“People do single-stocks more when it’s a conviction trade or when it’s a name that they like like Apple,” he said.

“Worst-of have not been on single stocks for the most part. I don’t think that they will.”

If volatility fails to rise or if it even shrinks, which to Halo’s Rosenberg “is the biggest risk,” a new generation of worst-of deals could emerge, one with more risk.

Issuers will have to add more underliers to generate acceptable coupons, he predicted.

“Income products with several underlying indices will be in vogue. I can see more use for the S&P, the Russell and the Euro Stoxx, all in the same structure,” he said.

Autocalls on the roll

Volume this year will also depends on the continued popularity of autocalls. While autocalls and worst-of overlap (most worst-of deals have a call feature), what matters in terms of notional growth in the overall market is clients’ willingness to roll.

So far it has overwhelmingly been the case.

“The deals that we put out have been called, and it was a successful experience for investors,” said John Tessar, managing director, head of structured products at JVB Financial Group.

“They made money. Success breeds success. People are eager to go back in the same trade.”

This experience is shared by many on the sellside. The nature of autocalls, which are short and renewable investments, is the seed of future deals.

“The entire market has rallied. We saw more calls,” said Olden Lane’s Rosenberg.

For Tessar, autocallables not only roll, they also create new business opportunities.

“When those deals get called, it creates an acceleration not only of the volume of money going to these products but also in interest for these products,” Tessar said.

“As people see success of other people, they get into the same trades.”

But more volatility would help in the process, said a sellsider.

“Investors rolling their autocalls feel frustrated with the returns they’re getting,” this source said.

“It’s getting harder to get those rolls.

“People with 8% coupon get called. Their advisers say: we’re going to replace it with 6%. How am I going to replace my income stream?”

Once again, volatility is going to be a determining factor in how deals will get made and how much will get sold.

“We will see more worst-of this year only if volatility stays where it is. If the VIX goes up, we may see a departure from the trend,” said Sowinski.

Maturities

Another possible evolution if volatility remains subdued is the extension of maturities.

The sellsider predicts it could happen with autocallables.

“Income strategies will continue to be a very significant part of what’s getting done.

“But I think longer maturities will grow the autocallable bucket,” the sellsider said.

He predicts maturities in those products extending to four to five years.

“As volatility has decreased, it’s more difficult to price attractive coupons,” he said.

“We’ll see more and more autocalls on the longer end,” he said.

This trend will appeal mostly to the more conservative investors, not everyone.

“The longer the term, the more likely you are to recover from a bear market or a correction. You simply have more time.

“Alternatively, they may also want this to be part of a laddered portfolio and be able to diversify across different maturities,” he said.

Coin mania

Speculation could also be a side effect of low volatility if it persists.

Case in point: the bitcoin frenzy, which most Wall Street analysts see as a textbook example of a bubble, similar to the Dutch Tulip Mania of the 17th century.

In December, bitcoin gained in legitimacy, making its futures trading debut on two large U.S. exchanges, the CBOE Global Markets and the CME Group.

For Halo’s Rosenberg, the banks will follow.

“We’ll see increased demand for bitcoin. I believe that in 2018 we’ll start to see some issuing notes on bitcoins,” he said.

“There will be an open market for it. A lot of people are eager to short bitcoin. With the futures contracts now trading on major exchanges it will be feasible.

“It won’t be unreasonable for a bank to consider issuing notes on bitcoin,” he said.

“I’m not saying I’m pushing it.

“But the launch of the futures is clearly opening the doors for structured notes to come up next.”

Technology push

Another trend for 2018 everyone expects will push volume to higher levels is technology.

Volume for the year has in a large part been facilitated by a soaring number of offerings, up more than 42% to 12,810 from 8,997, according to data compiled by Prospect News. The ability to use online tools for the pricing of many more although smaller deals has something to do with the recent pick up in volume.

“Technology helps level the playing field,” Halo’s Rosenberg said.

“It gives investors the ability to get more issuers diversification. Our platform teaches them what structured notes are. More people understand the benefit of it. It contributes to expand the market for structured notes.”

Halo is not in the business of taking others’ market shares, the trader said. His firm, he noted, cooperates with different actors, such as banks, distributors and RIAs.

Clients use the Halo platform to submit bids to up to seven or eight banks.

“It’s anonymous. They don’t know who you are. This blind auction mechanism makes issuers more competitive. People get 20 iterations of one note and they can figure out the terms they like.”

“Technology brings accessibility to better pricing, help customize structure and diversify credits across multiple issuers,” said Rosenberg.

“We, in technology are just part of the overall growth process.”

These advances may not go without growing pain. There is a need to weigh the benefits against the drawbacks of the new disruptors. The benefits of traditional distribution channels should not be minimized, said SPA’s Styrcula.

Volume and margins

“The new technology platforms for structured notes will focus on RIAs first, since it is more difficult to penetrate existing broker-driven distribution channels,” said Styrcula.

As a result, the platforms will offer smaller-sized bespoke transactions, in size possibly as low as $250,000.

“Technology will clearly bring new money to structured investments from RIAs and their investor clients,” he predicted.

“But a question mark for 2018 will be whether the expansion of the notional sizes will offset the inevitable margin compression that technology brings to the financial services industry.”

While startups like Halo or others such as Transparitrade Inc are changing the way deals are priced, the banks are also exploring the benefits of automation. Goldman Sachs for instance has its own web tool named Simon, which may be open to others, according to various news reports.

So where does the market go from here? Who will be the winners and the losers in the distribution game: tradition or innovation? Styrcula said that the old-school so far has the upper hand.

“Despite the technology revolution with the new platforms, the established private wealth distribution channels are likely to maintain the status quo for 2018,” he predicted.

“Private banks and mass affluent channels already have sunk costs in their own native technology to aggregate orders, keep track of the monthly calendar, book trades. No need to fix what isn’t broken – UBS, BofA Merrill Lynch and JPMorgan Private Bank will continue to increase the notional in the old-fashioned way – powerful marketing, strong salesmanship and a culture that recognizes the value of structured investments to achieve clients’ objectives,” he said.

“I think the issuance volume should be growing slowly and steadily next year. We should be up between 5% and 10%.” – Robert Sowinski, managing director, head of structured products at Advisors Asset Management

“Everybody wants income, and you can’t get it through CDs. You need some equity risk.” – Sam Rosenberg, managing director with financial services firm Olden Lane

© 2015 Prospect News.
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