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New Developments in HNW Structured Notes

Julian Lewis, 19 March 2007

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The market for structured notes targeted to high net worth investors and private banks has seen a decisive shift in emphasis over the past year.

The market for structured notes targeted to high net worth investors and private banks has seen a decisive shift in emphasis over the past year. This has broadened it and made it notably less dependent on the most common asset class – interest rates. As a result, it now offers investors a richer and more useful variety of tailored risk exposures. Traditionally, the structured note market (both internationally and in the US) has been dominated by interest rate-linked structures – that is, notes packaging interest rate derivatives such as swaps and options into the format of a tradable and often listed security. Now, though, the market is rather more evenly balanced. Rate structures still represent the largest single contributor to overall volume. But the majority of activity has shifted to securities whose performance depends on non-interest rate underlyings – both from major asset classes, such as equities, equity indexes, currencies and inflation (as explored by WealthBriefing in an earlier article last year), and from minor or emerging areas such as commodities, credit and funds, as well as the very important and rapidly growing market for multi-asset class hybrid structures. Non-Rates Head North The international structured note market saw non-rate sales of some S147.2 billion from just over 12,500 issues last year, according to data provider mtn-i.com. That compares with $67.3 billion (5,800 issues) in 2005 and $60.9 billion (4,700) in 2004. Note that “international” in this context excludes US domestic transactions under US law and cleared and settled via the local infrastructure, even where they involve a foreign borrower or investor. This powerful growth trajectory contrasts strikingly with the story of the interest rate-linked sector over the same period. It saw 2006 sales of some $93.9 billion from just over 4,600 issues, according to mtn-i.com. That compares with $133.8 billion (5,600 issues) in 2005 and $131.6 billion (7,100) in 2004. Rate products were almost 70 per cent of the structured market in 2004 and two-thirds of total activity in 2005. These two years may be viewed as a high water mark since between 2000 and 2004 the interest rate-linked area accounted for a still dominant but less overwhelming 59 per cent of structured note flows. Nonetheless, what is key here is that rate structure transactions declined hugely last year, both in absolute and relative terms. As a proportion of the overall international structured note market, the interest rate-linked sector fell in 2006 to a historically unprecedented 39 per cent, mtn-i data shows. Put another way, last year saw as many non-rate structured note transactions internationally (12,500) as the entire structured note market outside the US – rates and non-rates - delivered in 2005. Nor does this appear to be a pure one-off. This year too the rates area remains under 40 per cent, though it has regained a sliver (around 0.6 of a percentage point) of market share during the first quarter. Steepener Suspicion What is the cause of the dislocation between these two areas? Fundamentals are part of the explanation, of course. A period of generally rising rates across the world is not a conducive background to sustained growth in generally bullish interest rate-linked instruments. But rates have been rising globally since before the start of last year. A critical further factor is more technical. Many HNW and private bank investors supported 2005’s massive growth in notes linked to longer-term yields – typically, constant maturity swap (CMS) rates. A significant proportion of these were so-called “steepener” structures. These assume that the US dollar or Euro yield curves remain in the classical condition of long-term rates being higher than short-term ones – and reward increases in the underlying curve’s steepness. When first the US dollar curve inverted and then its Euro counterpart flattened and even inverted at times, the performance of these notes – which in 2005 were often both highly leveraged and structurally subordinated – suffered. Against this background, it is unsurprising that many HNW and private bank investors have been reluctant to take further aggressive yield curve exposure through steepeners and similar structures such as CMS spread range accruals. These are notes that pay an above-market coupon so long as the yield spread between two rates, such as 30 and 2-year swaps, remains within a pre-determined range – typically at or above zero. Although the structure can accommodate inversion of the curve (paying out so long as the spread is above -0.2 per cent, for example) or, alternatively, be set more demandingly for sustained non-inversion; in the US, the product is known as a “non-inversion note” (NIN). Of course, more defensive rate products are also available. Simpler structures such as one-time or multi-callable fixed-rate notes, capped floating-rate notes (FRNs) and “flip-flops” (fixed-rate notes with an option to flip to a floating rate, or vice versa) have always been an important part of the rate structure menu and have prospered in the more cautious post-2005 era. Extending the Spectrum But the key new development since the start of last year has been the broad trend for HNW and private bank buyers to take structured exposure to non-rate asset classes. A host of products of varying complexity has contributed to the growth identified above in the non-rate areas. These range all the way from simple zero-coupon equity index structures that trade a capped return for principal protection to hybrids whose payout may depend on two fairly uncorrelated underlyings, such as a precious metal and an equity benchmark, or a blue-chip stock and a money market rate. Longer-established products such as the FX basket and equity reverse convertible have thrived in this environment. The former is typically a fully principal protected note giving a long position in a number of currencies, usually tracking their performance against a major such as the US dollar or Euro; some part of the capital guarantee may be foregone in order to leverage potential upside, though sub-90 per cent protection is rare. The structure provides an efficient way of taking a macro bet on emerging markets, for example. It can provide a global combination of currencies, such as those of the BRIC (Brazil-Russia-India-China) group, or a purer regional play (up to eight local Asian currencies have been packaged in this way, for example, or a number of newly acceded EU currencies from central and eastern Europe). The venerable RCV, meanwhile, is enjoying phenomenal growth in the US currently with HNW sales through national broker-dealer networks repeatedly delivering $100 million-plus transactions on popular stocks. Recent jumbo deals have included plays on Advanced Micro, Analog Devices, Archer Daniels Midland, Best Buy, Cisco, DR Horton, Halliburton, Qualcomm and Texas Instruments. The product provides a very high coupon (often double-digit and sometimes even above 20 per cent) in return for the investor taking on the risk of receiving settlement in the underlying stock if it falls below a specified percentage of its initial level. It has also received a new lease of life in its role as the workhorse of international equity-linked sales through the emergence of auto-callable structures. Ranging Ever Further Other key trends include the transfer of rate structure technology to non-rate underlyings, such as range accruals on equities (combinations of Chinese stocks have been popular), commodities (typically oil or precious metals and sometimes in protected or “wedding cake” format, where several ranges with progressive payouts are employed) and currencies. This trend has recently moved on to inflation and credit underlyings as well, while it has also meshed with the emergence of dual-reference range accruals on rates to provide hybrid exposures of the type discussed above: a recent combination was that of the Nikkei 225 and gold, for example, where the note pays out an above-market combination so long as each of these disparate underlyings continues to trade within its pre-determined range. Elsewhere, the use of CPPI (constant proportion portfolio insurance) and Sharpe ratio technologies is bringing particularly innovative growth to the fund-linked note area.

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