The dislocation in the credit markets may have sounded the death knell for structured credit, but any slowdown in business on that side was more than made up for in other asset classes.
As early as March 2008, interest rate and foreign exchange traders in Asia were boasting that they had made their budgets for the year. Volatility in the US dollar interest rate yield curve and in the US dollar itself had completely reversed. It soared from the very low base that had been set over the previous couple of years.
During the last reaches of the credit rally, asset prices were universally expensive and volatility excessively low as structured products became increasingly leveraged in order to eek out that last drop of return for investors. It all changed over the course of the last year as volatility moved dramatically higher.
Up until the end of the fourth quarter 2007, equity structured product desks continued to benefit from a long bull rally in Asia that had seen huge volumes of structured notes being placed.
“It was the best ever year for equity structured products [in Asia],” said Min Park, head of the risk management products group at UBS. “Both retail and private banks were very busy buyers of these deals.”
Up to 10%–15% of total private banking assets were said to be held in structured equity products, according to Park, and more than 80% of the structured products markets was equity based.
Retail preferred the more common correlation products such as range-accruals, doubles and triplets, wrapped round the security blanket of principal protection. Private banking clients, meanwhile, on the look out for high-risk/high-return investments found accumulators more of an attraction.
These deals work well in a rising market, but as the year turned, share markets became both more volatile, and more correlated. As markets swung sharply up and down, all shares moved in the same direction at once, thereby increasing correlation. Stocks that would otherwise be completely unrelated were suddenly reacting to the same mass buying and selling pressures.
The conditions did not favour the “accumulator” and auto-callable products that had been sold in their billions.
Accumulators played on a seemingly straightforward pitch: if you like a stock at certain target level, then you should be happy to accumulate those shares at a discount. The investor is effectively short a put in the instrument – he is obliged to buy shares at a set price, should the stock fall below that threshold.
In a bull market, the product works wonders. In a bear market, the investor is obliged to take shares if they fall under a specified bar, usually 80%–90% of the market price at the start of the contract.
According to a report by ABN AMRO issued at the beginning of the year, private banks had sold a total of US$43.2bn accumulators, many of which were leveraged.
Auto-callables provide investors with exposure to tail risk: a basket of shares where the pay-out is based on the price of the worst performer in the basket being above a set barrier after a set period of time. If this is achieved, the structure knocks out and the investor receives a coupon.
An auto-callable investor is buying correlation and selling volatility. The best-case scenario for investors is that the basket of stocks is highly correlated and trades with low volatility.
The issuer is short correlation and long volatility. The worst-case scenario for the issuer of such products is that they knock out quickly.
In such situations, the issuer is left with a hedge on a deal that no longer exists, leaving issuers needing to buy back volatility. On the other hand, when the spot prices on the basket dropped, they needed to sell more volatility in the market in order to increase their hedges.
Dramatic and highly correlated market movements sent issuers rushing to sell volatility as markets tanked, or to buy volatility en masse as markets spiked to hedge. It added a peculiarly Asian twist to the Asian equity derivatives market.
The increase in volatility has seen a shift away from equity as the underlying asset class of choice, with foreign exchange, rates and commodities playing an increasingly prevalent role. Still, Park reckons that 60% of business in 2008 remained equity based, although there has been a reassessment of risk appetite.
“Structures have become more conservative; plain vanilla; and principal protected,” said Park. “Even without principal protection, they need to include minimum coupons and safety features as well as some upside on the equity.”
Outright exposure to equity has been painful for Asian investors, as has their experience on structured deals. The Dow Jones Shenzen index, for instance, went up 170% over the course of 2007 (from 189 to 512) but had lost almost all of that (down around 60% to 214) by early October.
That kind of price action took out many of the pure speculators but it also resulted in huge flows into foreign exchange as an asset class.
The first six months saw clients keen take on local currency exposure but that changed as problems in the Korean and Indian economies developed. Demand for China remained a common theme, however.
"For the first part of 2008, investors were willing to pay anywhere between 6% to 10% per annum for the privilege of holding the Chinese renminbi via the NDF market. Being purely long the forward contract was a very expensive way to bet on CNY appreciation," said Giovanni Amanti, director of FX structuring at Barclays Capital." Due to the increased demand in CNY exposure, we developed a number of innovative solutions offering an attractive risk/return profile despite the steep appreciation implied by the NDF market."
Equity correlation-type structures have also been shown up in the foreign exchange market where bankers said that simple, short-term range accrual products using yen as a proxy for the Rmb were in demand.
Elsewhere, the volatility in the US dollar interest rate curve may have been expected to resurrect the bandwagon of steep yield curve products that were so popular in 2005 and 2006, prior to the Fed beginning its round of increase rate raises. Yet, it has not been such a straightforward story this time around.
“The steepeners from a few years ago were such a good proposition as curve volatility was extremely low,” said Amanti. “Now, volatility is high and the swap curve has not steepened as much as the Treasury curve. Curve risk may not have done so well this year.”
On the corporate side from Asia, the curve that has increasingly attracted interest is not that of the dollar but of the euro, especially from China, according to bankers.
Another key beneficiary of the equity outflows in 2008 was the commodities market where new trading paradigms were quickly being established.
Prices in gold, oil, metals and agricultural goods were all taking on bubble-like proportions, fuelling fears of inflation reaching levels reminiscent of the 1970s oil-shock.
Unsurprisingly, adverts for commodity-linked structured notes started to appear in the hoardings to attract retail interest and there were attempts to develop product that would act as a proxy hedge for regional inflation in a market with no inflation-linked issuance.
Prices fell just as quickly as they went up, which has once again taking out those investors with a gambling mentality and ushered in a new, more cautious approach to investing.
"The days when you can make money by "buying high, selling even higher" have gone," said Chak Wong, head of structuring at Barclay Capital.
Poor old credit stumbled from one calamity to another. If the deterioration in prices across the structured credit markets was not bad enough, then the default of Lehman Brothers added another layer of confusion.
One of the major counterparties to swap transactions disappeared overnight; it was also included as a reference entity in a number of CDOs placed throughout the region. Perhaps just as importantly for Asia, it was a key player in the structuring of credit-linked notes sold into the retail networks of Australia, Singapore and North Asia.
Its downfall led to protests in the streets of Hong Kong and accusations of false selling as mums and dads looked for someone to blame for the loss in their savings.
It is not all doom and gloom for structured products, however. The hordes that follow trends may have been squeezed out of the market, but bankers report that cash-rich clients are coming back in the hunt for bargains.
“General risk appetite is going to drop and the amount of leverage is going to be less and more expensive,” said Chak Wong, head of structuring at BarCap. “But for the smart money, more interested in substance than form, then there will be some great opportunities in buying long products and selling volatility.”