Lowest Market Volatility Since 2007 Dividing Structured Notes

The lowest volatility for stocks, interest rates and commodities since 2007 is cutting potential returns on structured notes such as reverse convertibles and favoring securities in which capital is protected.

The Chicago Board Options Exchange Volatility Index, known as the VIX, touched a 5 1/2-year low of 12.43 on Jan. 22, according to data compiled by Bloomberg. U.S. sales of reverse convertibles, high-yielding bank bonds that convert into stock if a company’s share price plummets, fell to $466.6 million in the fourth quarter, down from $776 million a year earlier when the VIX averaged 29.94, Bloomberg data show.

Central bank efforts to curtail the global financial crisis and boost economic growth, such as the European Central Bank’s unlimited bond-purchase program and quantitative easing in the U.S., have calmed markets. Options embedded in structured notes are cheaper when volatility is lower, damping returns on securities where an investor is effectively selling an option and benefiting securities where the investor is a buyer.

“Volatility is higher in uncertain environments, but there is now a feeling that the crisis is under control,” said Johan Groothaert, global head of investment products and platforms at UBS AG in London. As a result, investors will probably shift to structured notes that allow them to benefit if volatility rises, he said.

Embedded options

The options embedded in a capital-protected structured note that pays out any positive returns of an underlying stock become cheaper when volatility is lower. That enables issuers to create securities with more attractive terms.

“Products that will become more attractive in the current low-volatility regime are products that are long volatility, meaning investors are getting exposed to a given asset for a lower price than before,” said Julien Lascar, head of distribution and structured equity products in the Asia-Pacific region at Societe Generale SA.

In reverse convertibles, the buyer effectively sells the issuer a put option, the value of which is used to make the security’s returns and other features more enticing. That option cost $125,246 for a $1 million, two-year reverse convertible tied to the Standard & Poor’s 500 Index, sold on Jan. 23, 2012, Bloomberg data show. The same option on Jan. 23 this year cost $90,145, or almost 30 percent less.

The level of interest rates - close to zero in Europe and the U.S. - is having an even greater effect on the pricing of structured notes than volatility, said Christian Kronseder, senior director of sales and public distribution for Switzerland at Royal Bank of Scotland Group Plc in Zurich. When rates decline, the zero-coupon bonds used to create structured notes become more expensive, leaving banks with less money to allocate to options that can be used to sweeten the terms.

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