Deutsche's equity basket notes linked to several ETFs lower costs, match market appetite

By Emma Trincal

New York, Sept. 16 - Deutsche Bank AG's planned equity basket notes linked to several exchange-traded funds may illustrate a nascent trend that fits the needs of structurers and investors alike, market participants said.

The London branch of Deutsche Bank plans to price equity basket notes due Sept. 30, 2014 linked to a basket of exchange-traded funds, according to an FWP filing with the Securities and Exchange Commission.

The basket includes equal weights of the Oil Services Holdrs trust, Market Vectors Gold Miners ETF, SPDR S&P Metals & Mining ETF, iShares Dow Jones U.S. Real Estate index fund, iShares MSCI EAFE index fund, PowerShares QQQ trust, series 1 and iShares Barclays 1-3 Year Treasury Bond fund.

"There have been a few deals linked to ETFs but usually linked to a single ETF as opposed to a basket. From that regard, I think it's certainly an innovation," said Anna Pinedo, derivatives lawyer with Morrison & Foerster.

"While it's increasingly more common to see a structured product inked to more than one ETF, it's certainly unusual and it's not the norm," added Cory Colvin, director of mutual funds with R W Baird & Co.

Experts say that structurers have two different types of incentives when using baskets of ETFs for the structuring of their notes: one is to reduce their costs and the other is to be able to satisfy investors' appetite for popular but not easily accessible asset classes.

More liquid, improved hedge

"Because ETFs are very liquid, it makes hedging easier," said Pinedo. "You can short them or have other trading strategies that involve ETFs. It's not necessarily done just through shorting." As for any hedging instrument, liquidity acts as a tool to reduce transaction costs.

"If there are options available on these ETFs and a decent liquidity on these options, it makes it easier and cheaper to hedge," said Colvin. "The exploding ETF market has led institutional investors to look for ways to hedge their positions. You have a demand for options on ETFs that comes from institutional investors and it creates another set of tools for investment banks to create structured products," said Colvin.

Exotic rush

The Deutsche Bank offering, which also comes in a different flavor - a three-year term carrying a 50 basis points lower coupon - is a deal that gives investors exposure to asset classes that are increasingly popular.

Pran Tiku, president of Peak Financial Management, Inc., a wealth management firm in Waltham, Mass., said, speaking about the market in general rather than the Deutsche deals specifically, that: "Typically, issuers in the past have structured their notes using S&P 500 Index or the MSCI index. But now we have an appetite for exotic products, such as currencies, commodities and emerging markets, which are easily available through ETFs. So it makes sense for sponsors to use ETFs more as a response to this general market trend."

Expensive inflation hedge

But a financial adviser said that investors are paying a dear price to access the increasingly trendy exotic and commodity markets.

"I could go out there and sell this deal like crazy. The news is selling it for me. Everyone wants gold," said Mark Trimmer, financial adviser with Applied Assets in Albuquerque, N.M.

"But I won't. The cap is too low. After inflation and taxes that's not a lot. I can do just as well or even better with a very conservative portfolio of a short-term muni fund and get a 3% return in less than one year."

The Deutsche Bank five-year notes will pay will pay a coupon equal to the average of the basket funds' returns on an annual basis on Oct. 6, 2010, Sept. 29, 2011, Sept. 28, 2012, Sept. 30, 2013 and at maturity. Each annual coupon will be subject to a floor of zero, and the return of each basket fund will be capped at between 5.75% and 6.75%. The exact cap will be set at pricing.

The same terms apply for the three-year note but the cap range on the coupon is 5.25% to 6.25%.

In each case, at maturity, investors get par plus their last coupon.

"We use structured products and alternative investments to protect our clients. But this structured product has a cap. And it's low," said Trimmer. "A ceiling of 5.75% and 6.75% for the five year is nothing to jump at."

Trimmer added that the product is designed to alleviate inflation fears but that the cost may not be worth it. "Bringing a package like this makes no sense in this environment," said Trimmer who added: "For months, now you've been reading in the news that we're heading for inflation. But we don't know that for sure. You have gold, oil, metals in the underlying. It's basically a marketing device. You sell clients a piece of portfolio to protect yourself against an inflationary environment."

The notes are expected to price Sept. 25 and settle Sept. 30. Deutsche Bank Securities Inc. and Deutsche Bank Trust Co. Americas are the agents.

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