Deutsche Bank links escalator notes to cross-asset basket; product reduces point-to-point risks, advisor says

By Kenneth Lim

Boston, Aug. 14 - Deutsche Bank AG's escalator notes linked to a cross-asset basket of indexes addresses some of the risks of point-to-point products, but investors may find it difficult to understand the underlying assets, an investment advisor said.

Deutsche Bank plans to issue zero-coupon principal-protection escalator notes due Sept. 16, 2013 linked to a basket of equity, currency and commodity indexes.

The basket consists of the MSCI EAFE index with a 16.67% weight, the S&P 500 index with a 16.67% weight, the Deutsche Bank Balanced Currency Harvest index with a 33.33% weight and the Deutsche Bank Liquid Commodity Index - Mean Reversion Plus Excess Return with a 33.33% weight.

Payout at maturity will be the greater of the basket return and the maximum lock-in level reached by the basket on any weekly observation date. The lock-in levels are 30%, 55% and 75% above the initial basket level. Investors will receive at least par.

UBS Financial Services Inc. and Deutsche Bank Securities Inc. will be the agents.

The Balanced Currency Harvest index reflects the value of notional long and short three-month foreign exchange forward positions in selected foreign currencies against the U.S. dollar. The index was designed to reflect a strategy of buying forward contracts on currencies with high interest rates and selling forward contracts on those with low interest rates.

The Liquid Commodity index reflects a momentum trading strategy that seeks to protect returns from downturns in the commodities markets.

Escalator eases point-to-point exposure

The escalator feature of the notes helps to reduce some of the risks involved in point-to-point products, the advisor said. Point-to-point products calculate their payouts based on the initial and ending levels of the underlying assets, regardless of how the asset moved in between.

"Point-to-point products on their own are risky because you can get trapped by short-term fluctuations," the advisor said. "As an example, if I have a one-year note linked to the S&P 500 and it pays me 1.2 times the underlying return at maturity if the S&P 500 is up. At maturity, if something happened two days ago that sent the S&P 500 below its starting level, I don't get my return even if the index was higher for six months previously."

The Deutsche notes allows investors to ride out the bumps, the advisor said.

"In this case you're not really that worried about the underlying volatility," the advisor said. "It's principal protected, so you won't lose any money. And you get the higher of the ratchet or the current increase in the basket, which is in the investor's favor."

Investors should mind gaps

But investors risk falling between the gaps in the ratchet levels, the advisor said.

"If the basket goes up by 54% but then drops back to 29%, you only get 30% back," the advisor said. "So you would have lost out on 24%. Making 30% in five years isn't very good, especially if you're like me and you're supposed to help people do better than the market. So there's still a risk there. It's not as much as without the ratchet, but it's still a risk."

The advisor said the cross-asset nature of the basket also introduces some complications for investors.

"I'm not sure what the correlation is between those four indices," the advisor said. "If there's negative correlation, which there could be because you're talking about equity, currency and commodities, then the basket may not go up very much, and your ratchets don't mean much if they're never used...But the currency and commodities components here are not market indexes, they're more like trading strategies, so I'm not sure what the correlation is."

Investors who are concerned about asset allocation may also find the product a little complicated.

"When you have something like this that's got exposure to three different asset classes, and you're trying to be a disciplined investor in terms of where you put your money, something like this gets a bit tricky," the advisor said. "The amount is split one-third in each asset class, but the product isn't really behaving like it would if you had three products, each one linked to just one asset class."

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