The latest in a string of U.S. rate rises is tipped to bring about a wave of structuring innovation in equity derivatives. Last week's hike brought the federal funds rate to 5%, which dealers said should breach a key psychological barrier for retail investors, who have not yet latched on to how rising rates are affecting their investments.
"We are now in a massively different rate environment, but it's taking people a while to realize this," said one structurer in New York. He predicted investors will start looking for yield-enhancement structures, such as high participation rates in equity indices, but it is not yet clear what form that will take. "My gut tells me we are probably on the cusp of another wave of innovation," he added.
Higher rates mean cheaper zero-coupon bonds, which can be combined with equity options to offer capital-protected investment notes. In turn, cheaper bonds give dealers more bang for their buck when it comes to buying the option component for these structures.
Cheaper zero-coupon bonds also mean structures can be fully capital-protected at shorter tenors. An equity salesman explained this is an important boost for the U.S. market where investors tend to prefer to lock money up only in the short term, and have not traditionally been interested in paying high fees for capital protection. Merrill Lynch, for instance, is already marketing a deal offering the upside of a covered-call index coupled with capital protection and also offering interest payments over its three-and-a-half-year term. Structurers at Merrill referred calls to spokesman Eric Hendrickson, who did not respond to messages.
Innovation may also be driven by the fact reverse-convertibles, which have taken the U.S. by storm in the last few years, may start to look less persuasive in the higher rates environment. Another structurer noted it's getting harder and harder to find names on which to write attractive reverse convertibles, hybrid instruments which combine a bond plus put option and can pay out high coupons.
Brian Jones, managing director at sructured product firm Incapital in Chicago, agreed interest rates affect investors' perspective of structured products. But he noted the value in reverse convertibles is also linked to the option's volatility, and if vol stays low, reverse convertibles will remain popular. "They continue to be a mainstay product for us," he noted.
