Rate Rise-Resistant Structured Note Sales Reach Two-Year High

Banks sold $548.3 million of U.S. structured notes in May that offer protection from rising interest rates, the most in almost two years, on concerns that borrowing costs may rise as the Federal Reserve prepares to reduce unprecedented stimulus measures.

The most popular such securities were those that eventually yield a coupon that floats above the London interbank offered rate, according to data compiled by Bloomberg. Sales also gained for notes that pay more when the difference increases between long- and short-term rates.

Securities that promise some protection from climbing rates can be a haven for investors concerned that yields will rise in anticipation of the Fed slowing the pace of its bond purchases and later raising its benchmark that’s been kept close to zero for a fifth year. An increase in the cost of borrowing lowers the value of fixed-rate debt.

“It’s the fear of rising interest rates that’s creating the demand for these kinds of products,” James Kochan, chief fixed-income strategist at Wells Fargo Asset Management LLC in Menomonee Falls, Wisconsin, said of fixed-to-floating notes.

Investors should be wary of a repeat of 1994, when they were surprised by an increase in interest rates that led to losses, Goldman Sachs Group Inc. Chief Executive Officer Lloyd Blankfein said at a May 2 conference in Washington.

The bank has sold the most rate-tied notes this year, with $529.8 million of issuance, Bloomberg data show. Of that total, 63 percent include securities that can perform well even if rates increase.

Funds Rate

The Federal Open Market Committee reiterated on May 1 that it plans to hold the federal funds target rate between zero and

0.25 percent as long as unemployment is above 6.5 percent and the outlook for inflation doesn’t rise above 2.5 percent. The economy expanded at a “modest to moderate” pace in 11 of 12 Federal Reserve districts, with broad-based gains ranging from business services to construction and manufacturing, the central bank said on June 5 in its Beige Book business survey.

“If the Federal Reserve responds aggressively to signs of higher growth and risky lending, credit market investors will meet a miserable fate,” Ben Garber, an economist at Moody’s Capital Markets Research Group, wrote in a May 23 report.

Banks sold $267 million of fixed-to-floating rate notes last month, 68 percent more than the $158.5 million of volume in April, Bloomberg data show.

Morgan Stanley issued $175 million of three-year notes tied to three-month U.S. dollar Libor on May 20, the biggest such offering since Feb. 13, Bloomberg data show. The securities yield 1.25 percent annually for the first 15 months before switching to 0.85 percent more than the benchmark, with the coupon capped at 5 percent, according to a prospectus filed with the U.S. Securities and Exchange Commission.

Similar Securities

Other institutions, such as the U.S. unit of ING Groep NV, have sold similar securities. The insurer issued $750 million of 40-year, fixed-to-floating-rate bonds in a private offering, the longest-maturity, dollar-denominated debentures the company has sold, Bloomberg data show.

The bonds, sold May 13, yield 5.65 percent for 10 years, then switch to 3.58 percent more than three-month Libor. The debt is callable after 10 years.

Sales of other types of structured notes that are somewhat shielded from rising rates have also gained.

Issuance of securities tied to constant-maturity swap rates rose to $118.1 million in May from $66 million the month before. The notes perform better when the difference between long- and short-term swaps widens.

Loan Fund

JPMorgan Chase & Co. sold $100 million of notes, in two offerings, tied to Invesco Ltd.’s PowerShares Senior Loan Portfolio exchange-traded fund on May 17, the first such note publicly offered and registered with the SEC. Most of the underlying loans pay floating interest rates, according to a prospectus filed to the regulator.

Total issuance of notes that offer some protection against increasing rates was the highest last month since $990.5 million in August 2011.

Meanwhile, May was the third-slowest month for callable step-up notes since January 2010, when Bloomberg began collecting comprehensive data on the securities.

Tiffany Galvin, a spokeswoman for Goldman Sachs, and Lauren Bellmare, of Morgan Stanley, declined to comment on the notes.

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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