Rates Favored Over Credit in Structured Notes as Swaps Rise

Sales of structured notes tied to interest rate moves are surpassing those linked to credit risk for the first time in 18 months as investors seek to profit from higher borrowing costs.

Citigroup Inc., Deutsche Bank AG and DZ Bank AG led sales of $4.7 billion of rate-tied notes in the third quarter through Sept. 20, exceeding $4.4 billion of credit-linked note issuance, according to data compiled by Bloomberg. That’s the first three-month period since the fourth quarter of 2011 where investors have favored rates.

Interest rate swaps, a key pricing component for certain structured notes, jumped since May when Federal Reserve Chairman Ben S. Bernanke signaled record stimulus will be unwound, allowing certain securities to be sold with higher coupons. The Fed said Sept. 18 it will refrain from reducing the $85 billion pace of its monthly securities buying on concern higher borrowing costs will curb growth.

“Clients are definitely becoming more interested in rate-linked products,” said Nathalie Naffi, who heads BNP Paribas SA’s dollar rates structuring and derivatives platform business in London. “While we don’t see an aggressive shift out of credit for rates yet, the tapering discussion has pushed up rates, boosting yields on notes and making them more attractive.”

Swap Rate

The 10-year dollar swap rate, which measures the cost of exchanging floating- and fixed-rate payments, reached a two-year high of 3.19 on Sept. 5 after falling to 1.8 percent in May, Bloomberg data show. The contracts were at 2.91 percent yesterday.

Three-month options on 10-year euro swaps, which can be used to gauge volatility in the market, are 74.83 basis points, compared with the average for this year of 66.39 basis points, Bloomberg data show.

Greater interest rate volatility has boosted sales of products such as range accruals that can offer higher potential returns when price swings are greater, said Naffi.

Citigroup sold $70 million of notes tied to moves in the three-month dollar interbank offered rate this month, Bloomberg data show. The third-largest U.S. bank by assets issued $50 million of 15-year callable notes on Sept. 9 that pay 6.8 percent for days Libor is between zero and 5.5 percent. The rate was set at 0.25 percent yesterday.

Popular securities in the third quarter also include those where the coupon increases with time, according to Bloomberg data.

Sales Slow

Sales of credit-linked notes slowed since $12.8 billion of issuance in the first quarter, Bloomberg data show. The $4.42 billion of issuance so far in the July-September period would be the least since the second quarter of 2004.

The cost of derivatives is a key pricing component for credit-linked notes and typically result in smaller coupons when prices fall. The Markit iTraxx Europe Index of credit-default swaps on 125 investment-grade companies dropped 16.7 basis points this month through yesterday to 89 basis points, the lowest since May 22, Bloomberg data show.

The narrower default-swap spreads, especially on financial companies “make conditions for credit-linked notes less attractive to investors,” said Sharif Nahas, vice president of structured product sales at ING Groep NV in Frankfurt. “Rate-linked notes are also easier to explain for advisers and that could also lead to higher relative sales.”

Credit-linked notes can have higher yields and tailored maturities that may not be available in the bond market. Buyers of the securities, which include private banks and wealthy individuals, typically suffer losses if the issuing bank or the linked entity defaults.

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