Tags: Investors | Risk | Long-Term | notes

Investors Snap Up Risky Long-Term Notes Tied to Stocks

Thursday, 28 March 2013 03:37 PM

U.S investors are betting soaring stocks can deliver higher yields through structured notes that potentially expose them to large losses and lock up capital for as long as 20 years.

Sales of equity-linked securities that mature in 10 years or more and can be redeemed early surged to $301.2 million in the first quarter, according to data compiled by Bloomberg. Banks issued less than one-eighth as many notes, $35.5 million, the year before.

Investor appetite for riskier assets has grown, with the Federal Reserve purchasing $85 billion a month of Treasury and mortgage debt to support the economy and the benchmark rate remaining between zero and 0.25 percent for a fifth year. The equity-tied securities depend on the performance of large stock indexes and eventually pay coupons as high as 15 percent a year, as long as they’re not redeemed early and markets don’t plunge.

The jump in sales is “a sign that investors are optimistic over the longer time horizon,” said Stephen Hemphill, partner at Alternative Wealth Group Inc., which distributes structured notes to 35 independent broker-dealers for Patrick Capital Markets LLC.

Morgan Stanley issued $110 million of 15-year callable securities tied to the Standard & Poor’s 500 Index on Jan. 15, according to a prospectus filed with the U.S. Securities and Exchange Commission. The sale is the largest among $5.86 billion of U.S. issuance linked to stocks this year.

Reverse Convertibles

With a long-dated callable note, investors often risk large losses identical to the declines of the underlying benchmark if the gauge drops beyond a barrier that can be 30 percent or 50 percent of the initial value. The notes somewhat resemble reverse convertibles, which put a buyer’s principal in jeopardy if the company’s shares plummet. In the U.S. though, reverse convertibles typically mature in less than a year and are tied to a single stock.

While the two products have similarities, long-term callable notes are “much more conservative,” said Serge Troyanovsky, managing director and head of North American structured product sales at BNP Paribas SA in New York. They are linked to indexes instead of more volatile individual stocks, he said, and the longer maturities mean better terms, such as bigger protective barriers.

For buyers of the securities, the payments are less certain. Investors don’t receive a coupon on dates when the index drops below a certain level. They also are stuck holding any securities that are paying little or no yield, while others that perform well are redeemed early.

Reinvestment Risk

The notes, which Bloomberg data show can be called as little as one year after issuance, put buyers at risk of not being able to reinvest their funds at the same rates, said Tim Dulaney, senior financial economist at the Securities Litigation & Consulting Group Inc., a Virginia consulting firm, in an e-mail. Issuers have redeemed two of the five securities eligible to be redeemed that have been sold since 2010.

The long-term notes, with their variable coupons and different call dates and barriers, are “just as complex” as reverse convertibles, he said.

Morgan Stanley’s securities tied to the S&P 500 Index, issued on Jan. 15, pay monthly coupons only when the benchmark is at least 70 percent of its initial value, according to the prospectus filed with the SEC. The coupon rises from 7 percent annually for the first five years, to 8 percent for the next five years, then 12 percent afterward until maturity. The bank, which distributed the notes for a 3.5 percent fee, can redeem them after five years.

The S&P 500 Index rose 9.6 percent this year to 1,562.85 Wednesday.

Lauren Onis, a spokeswoman for Morgan Stanley, declined to comment on the offering.

Banks create structured notes by packaging debt with derivatives to offer customized bets to retail investors while earning fees and raising money. Derivatives are contracts whose value is derived from stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.

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U.S investors are betting soaring stocks can deliver higher yields through structured notes that potentially expose them to large losses and lock up capital for as long as 20 years.
Thursday, 28 March 2013 03:37 PM
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