Deutsche Bank's leveraged notes linked to MSCI EAFE offer too little upside for risk incurred

By Emma Trincal

New York, Feb. 21 - Deutsche Bank AG, London Branch's 0% Accelerated Return Notes due March 2015 linked to the MSCI EAFE index provide insufficient potential return given investors' full exposure to market risk, said Gurdeep Ubhi, structured products analyst at Future Value Consultants.

The payout at maturity will be par plus 300% of any index gain, up to a capped return of 11% to 15%. The exact cap will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will be exposed to any losses.

The final index level will be the average of the index levels on five scheduled calculation days shortly before the maturity date.

BofA Merrill Lynch is the agent.

The notes fit into the "leveraged return" category in Future Value Consultants' methodology, he said. This product type includes notes with various maturities, caps and downside protection levels, including none as it is the case with Deutsche Bank's notes. The category enables the research firm to compare the notes to products of the same structure type when assigning scores.

"It's a one-year leveraged note, three-times geared on the upside without any downside protection," Ubhi said.

"We are comparing it to all other leveraged notes recently rated.

"The cap is between 11% and 15%. We picked 14% for our scores."

By convention, Future Value Consultants uses in its models a hypothetical cap situated 25% below the upper end of a range when a term is not fixed. With an 11% to 15% range, the hypothetical cap would be 14%.

Mildly bullish

"The product is designed for investors who are probably looking into maximizing their return based on the anticipation of a moderate index growth. You have a high gearing of three," he said.

"Investors in these notes really need the index to grow. They're trying to use the leverage as a way to capitalize on a very small appreciation of the index. It is not a particularly bullish instrument. More bullish investors would have invested in a non-capped or a higher capped product. This product is for someone who is mildly bullish on this particular index."

The one-year implied volatility of the MSCI EAFE index is around 12%.

"It's not a very volatile index," he said, comparing it with the implied volatility of the S&P, which is 15%.

Market riskmap

In order to assess the risk of any given note, Future Value Consultants created its "riskmap," a score that measures risk on a scale of zero to 10 with 10 as the highest level of risk possible.

The riskmap is the sum of two risk components: market risk and credit risk.

The market riskmap at 2.91 is higher than the average score for leveraged return notes, which is 2.59, according to the firm's report.

"There is more market risk than average here even though the underlying index is not that volatile. This is due to the fact that we don't have any protection on the downside," he said.

"A lot of these notes in the leveraged return category normally have a buffer or a barrier which protects some of the downside. Here, the investor is fully exposed to the downside, which enhances the market risk.

"This investment is the equivalent of a direct holding in the index without dividends."

Credit risk

On the other hand, the credit risk associated with the notes is below average, the report showed. The notes have a credit riskmap of 0.45 versus an average of 0.65 for products of the same type.

"The credit risk is lower. That's very much based on the short-term aspect of the notes. The average of the product type duration is normally greater than one year. So we have a credit risk that's lower than the average for this product type.

"But the lower credit risk is not enough to bring the overall riskmap down since the market risk is so much higher.

"As a result, we're left with a riskmap that's higher than the average for the same product type."

The notes have a 3.36 riskmap, compared with an average 3.24 score for the category.

Return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

With this product, the best scenario is bullish.

The return score on these notes is 6.88. In comparison the average for the same product type is 7.77.

"We have almost a point difference," he said.

"This is very much a result of the higher riskmap. With that level of risk, the product would need a higher cap. So it's a combination of the two because the score measures the risk-adjusted return. To get a higher return score, you have to either get more upside potential or some kind of downside protection.

"We can't tell by just looking at it that the cap is low. It's the return score that tells us that the cap is low because you take the risk into account. What the score suggests is that for the level of risk you are taking, you're not getting adequately compensated."

Price score

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The price score is 6.74 versus 7.72 for the average leveraged product.

"Here it's really one point [of] difference from the average, and that's a lot," he said.

"The value of the product is lower because it's not priced as competitively as the average product in this category.

"If the price score is not very impressive, the reasons remain the same. It's because you have at the same time a lower cap and more risk than average.

"If the cap was higher, the price score would be better. The cap they offer - and we've used the 14% value - is not sufficient based on the risk investors are exposed to. If it was more, investors would have an opportunity to make more gains."

Overall score

Future Value Consultants offers its general opinion on the quality of a deal with its overall score. This score is simply the average of the price score and the return score.

With this product, the overall score of 6.81 lags the average for the same product type of 7.74.

"This low overall score is easy to explain. The overall is the average of the price score and return score. Since both scores are lower, it's only natural that the overall would be less than average," he said.

"With the absence of any downside protection, this product is not bringing enough on the upside to compensate for the full exposure on the downside."

The notes will price in February and settle in March.

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