Investors are starting to buy options and swaps tied to stocks instead of structured notes that use the derivatives as declining volatility makes the contracts a more attractive purchase.

U.S. sales of equity-linked notes and reverse convertibles, high-yielding bank bonds that convert into stock if a company’s share price plunges, have dropped 16 percent this year to $17 billion.

Fund managers say they’d rather buy directly in the options market, where prices have decreased, than pay a premium for the notes. Volatility, as measured by the Chicago Board of Options Exchange, known as the VIX (VIX), has fallen 31 percent to 16.21 this year. When price swings are expected to be smaller, options to buy and sell stocks at set prices can be purchased more cheaply.

“Notes are great because they’re efficient, but if the returns aren’t there, we have to look elsewhere to try to achieve that,” John Farrall, director of derivatives strategy at PNC Wealth Management in Cleveland, said in a telephone interview. The fund has $112 billion in assets under management.

Low volatility also makes it harder for issuers to create certain types of equity-linked notes with enticing terms such as large coupons or big cushions against losses. At the same time, fees on U.S. products tied to stocks have been as high as 7.85 percent this year.

“With volatility as low as it is, those associated fees become a bigger drag on performance,” said Max Breier, senior volatility trader at BMO Capital Markets Corp. in New York.

Counterparty Risk

Moving away from structured notes also reduces counterparty risk, said Jerry Miccolis, chief investment officer of Brinton Eaton Associates Inc. in Madison, New Jersey. There’s too great a chance that the banks guaranteeing payment on the notes could fail, he said.

“We’ve been replacing structured notes with other vehicles over the last twelve months,” he said in a telephone interview. Brinton Eaton bought swaps with a face value of $80 million to hedge its investments, and didn’t have to pay any upfront costs, he said.

Accuvest Global Advisors likes options after buying two structured notes from Lehman Brothers Holdings Inc. that plunged in value after the company declared bankruptcy, said David Garff, the company’s president and chief investment officer.

“The bottom line for us on structured notes vs. options is that options are more simple vehicles that don’t imply the same level of credit risk that structured notes do,” he said in an e-mail.

To contact the reporter on this story: Kevin Dugan in New York at kdugan4@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net.