Jan. 11 (Bloomberg) -- Interest rate-linked structured notes, which had their worst month for sales in December in almost 12 years, are making a comeback with investors seeking higher returns as corporate bond yields near record lows.
Issuance of the securities totaled $940 million in the first seven trading days this year, compared with $609 million in the whole of December and an average $1.9 billion a month throughout 2012, according to data compiled by Bloomberg that exclude the U.S. Last month’s sales were the least since banks sold $342 million in January, 2001.
Corporate bond yields are approaching record lows and the cost of default protection on European banks is now the least since April 2011 after the European Central Bank offered unlimited funding and its president, Mario Draghi, pledged to do whatever is needed to preserve the euro. Rate-linked notes can pay coupons more than five times higher than vanilla bonds.
“With issuer credit spreads tightening last year, the hunt for yield is going to become even more chronic,” said Sumit Mehta, head of inflation structuring with responsibility for interest rate-linked structured products at Royal Bank of Scotland Group Plc in London. “Some of the excess cash buffers that have been built into the system will lead to structured product demand.”
The cost to insure against default the debt of the 25 European banks and insurers in the Markit iTraxx Financial index has fallen 56 percent since July 26, the day Draghi vowed to save the euro, to 124.5 basis points. Yields on corporate bonds plunged 53 percent to 2.01 percent on Jan. 10 from 4.31 percent a year earlier, Bank of America Merrill Lynch’s Euro Corporate Index shows. Investors can get higher returns from buying the bonds of issuers with greater credit risk.
DZ Bank AG, the biggest issuer of structured notes in 2012, raised $237 million from rate-linked securities this year. The Frankfurt-based lender sold 40 million euros ($53 million) of callable step-up coupon securities on Jan. 2 that pay an initial coupon of 1.7 percent before increasing annually to a final rate of 2.6 percent.
Investors are also buying rate-linked notes because they believe the volatility of interest rates, which fell to the lowest level since April 2010 in December, will further decline this year, said Vincent Berard, head of interest rates and foreign-exchange structuring at BNP Paribas SA in London. When interest rates are less volatile, the options embedded in structured notes are cheaper, resulting in lower potential returns on notes.
The so-called 3m10y swaption rate, which is a measure of volatility in three-month options for 10-year euro interest-rate swaps, fell to 57 basis points on Dec. 6 from 104.9 basis points on June 15, the highest point of 2012, Bloomberg data show. The rate now stands at 61.2
“January is usually the busiest month for note sales and we are already seeing demand for callable rate structures, but we will have to see if issuance will keep this pace for the rest of the year,” said Thilo Rossberg, head of rates structuring at Landesbank Baden-Wuerttemberg in Stuttgart.
Investor demand for higher-yielding securities will benefit other types of structured securities, including credit linked-notes, which had the best year for sales in four years in 2012, said Phil McCabe, head of structuring at Lloyds Banking Group Plc.
“In the current less leveraged market, a combination of factors from low interest rates to tighter bank funding levels and a flatter yield curve makes rate-linked notes appear less attractive to some investors when compared to, say, credit-linked alternatives,” said London-based McCabe.
Structured notes package debt with derivatives to offer customized bets to investors while earning fees and raising money. Derivatives are contracts whose value is derived from stocks, bonds, currencies and commodities.
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