Financial News

        Equity derivatives come back into vogue

        Simon Boughey
        14 Mar 2011


Equity derivatives bankers are smiling in relief now that their business, which less than a year ago was threatening to disappear, is back and turning a healthy profit.

The response to recent convertible bond deals tells the story. This month, French payment systems company Ingenico sold a €220m bond with a €30m greenshoe that attracted an order book topping €5bn.

The scale of the response shocked Ingenico’s bankers, but in a positive way. Strong demand was expected after such a long fallow period in convertible bonds, but no one had expected anything like this.

The usual convertible bond investors and fast-money buyers were well represented in the order book, but the managers co-ordinating the deal – Lazard-Natixis and Société Générale – reported that many buy-and-hold accounts and even some fixed-income investors showed an interest.

This is a far cry from the middle of last year, when the equity derivatives market was floundering and fixed-income markets offered comparatively attractive yields, though much lower than the no-brainer coupons of 2009.

But what was more important was the effect global volatility had had on equity values last year. Equity markets dislike volatility, and during the second quarter of 2010 there had been too much of it.

Just when buyers had begun to creep back into equity derivative markets, the sovereign debt crisis struck. Events last May were particularly damaging. Not only was the sovereign debt crisis at fever pitch, the flash crash on May 6, when the Dow Jones Industrial Average lost 1000 points in one day, made the prospect of taking equity exposure particularly unpalatable.

Bankers were worried that investors would not only fail to regain their appetite for equity investment but would reduce their existing exposure further.

Turning the tide

Senior equity derivatives professionals say the tide began to turn around September. Buyers started to return to the market, and things have felt much healthier since.

There are several reasons why equity exposure began to look more attractive in the third quarter of 2010 – the most compelling of which is yield. Last year marked a gradual return by investors to yield-bearing instruments – despite the sovereign debt crisis – and bonds began to look increasingly unattractive.

In the first week of this month, RCI Banque, the triple B-rated financing arm of Renault, sold a €750m five-year corporate bond at just 127 basis points over mid-swaps. Satellite operator SES, also rated triple-B, sold a €650m 10-year note at 137bp over mid-swaps.

But with money market rates stubbornly low, there was a limit to how much institutional investors could park in bonds of this kind before looking to take on equity exposure which often continued to promise annual yields of 8% or 9%. The yield grab was on.

It should also be noted that volatility has tailed off substantially over the past four or five months. On the first Friday of March, the Vix – the Chicago Board Options Exchange Volatility Index – dropped by 10% to 18.60.

This was the biggest fall that the benchmark index for stock options had recorded in three months. At the end of May last year, by way of comparison, it was trading above 45, which at the time were the highest levels recorded since the equity market lows of March 2009.

Not that there hasn’t been plenty for the Vix to get agitated about recently. Last May, the eurozone was worrying about Greece. Now it knows Greece is a basket case – and so too are Ireland and Portugal.

Then there is the matter of the Middle Eastern countries, most of which are sitting on substantial oil reserves, that are the point on civil collapse. Yet all this appears to have had limited impact on volatility. A senior equity derivatives banker said: “Sure, oil is $115 a barrel. No one cares. People are much more confident and there is no panic.”

There is no accounting for sentiment. But all this is good news for those shops that earn a high percentage of their trading revenue from equity derivatives. Pre-eminent among these are BNP Paribas, Deutsche Bank, JP Morgan and – the standout equity derivatives performer – Société Générale. A lot of bankers at these shops have been very relieved over the past few months to see their sector come back from the dead.

Regulatory fears

Only one thing still worries them – regulation. To be fair, it frightens a lot of bankers right now, but those in equity derivatives are particularly concerned that regulators’ obsession with central clearing and exchange trading, and the changes they are likely to implement, will paralyse areas of their asset class.

Central clearing of complex equity derivative products is not always feasible because consistent prices are not readily available. If these products are not cleared, though, the capital costs are likely to rise to such an extent that making markets is no longer cost-effective.

The forced listing of instruments on an exchange, with all the transparency that entails, is even more problematic for certain areas of the equity derivatives market. Another equity derivatives banker in London said: “I am frightened that misconceptions will kill the product. Listing something does not make it a better product.”

One hopes that European regulators will see sense on this one. Unfortunately, in the week that the economics and monetary affairs committee of the European Union voted to outlaw the taking of naked short positions in sovereign credit default swaps, this looks unlikely.

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