Scrambling for yield

The rebound of credit markets in 2009 enabled product providers to decrease risk as well as offer higher yields to investors in the Americas, using techniques such as multipliers or digital payoffs. The result is an increase in the number of deals, especially over the last six months. Richard Jory reports from the Structured Products Americas conference in Miami

Richard Vagnoni, Finra

The demand for certificate of deposit-backed structured products in the US will dwindle only when the increased, US$250,000 limit put in place by the Federal Depositary Insurance Corp in the depth of the financial crisis is reviewed. "You can't assume the FDIC limit will remain high," said Dayna Kleinman, first vice-president, fixed income and structured products consultant at Robert W Baird, speaking on a roundtable at the Structured Products Americas conference, held in Miami on May 6 & 7.

Longer tenors generally mean higher yields, and in a market where rates have been low almost any technique that increases returns for the investor will do. "There are a lot of mid-market institutions scrambling for yield," said Kelly Treseder, managing director at Cohen and Company. "Structured rates deals are in vogue," he added.

Investors preferred these products to deliver that income rather than capital gains. "Whether paying semi-annual or annual income, these products came in the form of callable step-ups and callable steepners," said Steve Peters, senior vice-president, Structured Products at JVB Financial.

And those buying do not mind paying tax on their gains, as long as the products are short term. Taking income rather than waiting for gains at maturity works because the perception is that taxes will raise, so better to pay them now, according to John Farrall, senior vice-president and director in the derivatives strategies group at PNC Wealth Management. Although Farrall warned of the difficulties of making "the bond chassis that a structured product comes in shows up as equity in the portfolio, just like a corporate bond".

Moreover, some of the financial advisers selling structured products do not understand what they have bought, according to Kleinman. And these investors are likely to have to come across more disclosure from the sellers, as the fallout from crisis starts to have an effect on new business. "The fastest growing department at Cohen's is legal and compliance," said Kleinman.

This change in disclosure standards has come as regulators like the Financial Industry Regulatory Authority (Finra) take a harder look at structured products. "Finra does not have a negative view of these products, in general," said Richard Vagnoni, senior market analyst at the regulator. "Finra's concern is how these products work and are understood... As the regulator, I sometimes need to take away the punchball if things start to get too exciting."

Vagnoni pointed to the Finra guidance note 03-71, which has outlined some of regulator's key concepts, such as due diligence and reasonable basis suitability. "A lot of these products are complicated and we look at the risks and what may influence these risks."

Finra has been producing plenty of guidance over the decade and has most recently turned its attention to reverse convertibles and principal protected notes, taking much its direction from a series of academic papers. "Some of these academics seem to think the profits [for providers] are too high," said Vagnoni. "And some products overweight that the chances of high returns and underweight the probability of low returns... These papers are definitely input to our thoughts."

The most recent public example of the regulator's work was its investigation into H&R Block. Finra was particularly concerned about the sale of reverse convertibles. Vagnoni noted the "lack of adequate systems to monitor sales and overconcentration of RCVs for a retired couple".

"We've seen a resurgence in reverse convertibles," said Vagnoni. "They offer high yields but they can be complicated and some investors and broker-dealers do not understand [them]. You need a reasonable basis [to justify their] suitability, based on the specific customer's financial condition and objectives, and you need to be knowledgeable about those things before recommending these products. Firms need to make a real effort to understand what they're selling, including the liquidity of the product, whether there is a secondary market, variance risk, credit risk, risk to principal, interest rate risk and what may influence those risks."

Capital returns

But all the time, investors have been turning to structured products for all the regular reasons. "Don't tell me about the return on my money... tell me about the return of my money," said Joseph Castelluccio, managing director, fixed income trading/structured products at Maxim Group, quoting Will Rogers.

The increased attention on listed products, ahead of rules expected from the Securities and Exchange Commission (SEC) but also following the introduction in the US of exchange-trade notes (ETNs) and also exchange-traded funds (ETFs) has helped to make the structured products market more transparent, said Castelluccio. "There is more transparency in structured products than in any other new investments created over recent years," he says. "They are complex, but not complicated."

US investors are still interested in invested in equities, or products that link to equities, but having seen the markets climb, they wanted protection against those markets falling. "The interest has not been so much in inflation, but it has been in currencies, especially when playing the euro or Asian currencies against the US dollar in products that have buffer-type protection," said Farrall.

Inflation and currency

While the panel convened to discuss inflation appeared to conclude that inflation was going to arrive at sometime over the coming years, their view was not universally shared by the audience, many of which voted for the likelihhod of deflation. "Countries do not go bankrupt; they print and print and print [money]," said Fred Magnamini, director of derivative products at EAM Partners, speaking on the same panel. "It's just a question of timing, when inflation will come," he concluded.

According to Adam Friedman, vice-president, structured products at Incapital, there have been a lot more notes based on baskets countries like Brazil, Austria, Norway and Canada (or ‘Banc'), reflecting the currency strength of these commodity countries.

"Currencies from commodity-rich countries will do very well in an inflationary environment," said Eric Glicksman, head of structured products and wealth management, Americas for UBS Wealth Management, citing Australia, Canada and Norway as examples. "UBS also has a strong view on the emerging markets, especially Asia. Play these currencies against the US dollar."

In common with others, Incapital has received plenty of requests for gold. "If you are going to take a view on gold, take at least a little of it in physical," said Friedman. "If we go to deflation, you want to hold onto money," he said, noting that gold was not behaving like a commodity and was more like money.

Concerns over credit risk

There is still a lot of concern over credit risk, on companies that should not be the subject of doubt, said JVB Financial's Peters. PNC's Farrall asked the question, "How much is the risk of counterparty risk and different from this risk for any corporate bond?"

"Telling a client that a product is capital guaranteed and therefore there is no need to worry about it is a thing of the past," said Farrall. By way of example, Todd Rongaus, vice-president and director at PNC said: "In a deal we did on February, we did not go for the best bid but went with the higher quality credit."

Durraj Tase, founder of DT Advisors, a member of the final panel on May 6 said: "It's all about volatility right now. You need a strong credit - it's not just the underlying. They have equal prominence."

And when it comes to making products for clients, with some exceptions, the desire is for simple products. "The importance of providing new products has gone down," said Barbara Mullaney, managing director, head of Americas retail structured products at Citi.

But even then, Tase suggested that the overall education of investors has been poor in the US. "We have not done as good a job as the mutual fund or the ETF industry... We need to educate more."

Latin America gears up

The evolution of capital protected funds in Chile will soon be followed by the development of the same technique in Mexico, Colombia and Peru. Furthermore, conference attendees were bullish about the improving conditions for structured products in Brazil.

"Latin American markets are not only being utilised by American, European or Asian investors, but also by local clients," said Rodrigo Covian, Miami-based head trader for emerging markets and the structured products group at specialist Latin America broker Bulltick Capital Markets. "Latin America is well positioned in terms of debt ratios, which are a real concern with the debt crisis in Greece and elsewhere in Europe. A lot of companies are having trouble with [European] financials and debt ratios, and although that is something that Latin America has struggled with for many years, I think the region has learnt that lesson and some countries - but not all - have their financials and debt ratios in order and are ready to attract a lot of investment."

Covian noted that, while South American investor capital poured into fixed-income assets during the financial crisis, low yields available on such paper currently may drive investors into the structured product sector in an effort to boost returns this year.