U.S. investors bought 57 percent less reverse convertibles this year as lower volatility dulled the securities’ appeal by reducing potential returns.
Banks in the U.S. issued $2.14 billion of the securities, according to data compiled by Bloomberg from notes registered with the U.S. Securities and Exchange Commission. Citigroup Inc. (C:US) led the decline, selling $62.4 million of the investments, 93 percent less than during the same period in 2011.
Low volatility is making returns of reverse convertibles less attractive for investors, said John Farrall, senior vice president and director of derivatives strategy at PNC Wealth Management in Cleveland, in a telephone interview. The options embedded in the securities, a kind of structured note that pays a high coupon though converts into stock when its value plummets, become cheaper when price swings are smaller.
“How many companies do you really want to take the downside risk of?” Farrall said. “It seems like earnings were still good, but maybe past peak.”
The VIX (VIX), as the Chicago Board Options Exchange Volatility Index is known, fell to a five-year low of 13.45 on Aug. 17. It has since climbed to 15.08 yesterday.
Sales of reverse convertibles also declined after the Financial Industry Regulatory Authority advised investors in July last year to be wary of advertising suggesting the products are “safe and suitable for investors seeking high yields.” After Finra’s statement, average monthly issuance of the securities has plunged to $233.8 million, less than half of the $577.8 million for the first seven months of 2011.
Demand for Citigroup’s reverse convertibles dropped in the second half of 2012 because of the market environment of low interest rates and low volatility, Barbara Mullaney, managing director and head in the Americas for Citigroup’s private investors product group, said in an e-mail.
The bank’s sales of all reverse convertibles, including those not registered with the SEC, fell 85 percent for the year ending October, said Carmen Binder, head of marketing in the Americas for Citigroup’s cross asset group.
While total U.S. issuance for the securities declined, investors bought $225.9 million of reverse convertibles tied to the shares of Apple Inc. (AAPL:US), 77 percent more than during the same period last year, Bloomberg data show.
“I think the main driver is that the stock has strong brand appeal and investors are looking for enhanced yields,” said Glenn Lotenberg, a managing director at Incapital LLC in Boca Raton, Florida, who’s responsible for U.S. structured note distribution.
HSBC Holdings Plc sold $35.3 million of one-year notes linked to Apple, the year’s largest reverse convertible offering. The notes, issued March 14, yield 7 percent a year, with principal at risk if shares fall below 92.4 percent of their initial value, according to a prospectus filed with the U.S. Securities and Exchange Commission.
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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