UBS barrier notes tied to Russell 2000 likely to yield small return despite high cap: analyst

By Kenneth Lim

Boston, July 2 - UBS AG's planned absolute return barrier notes linked to the Russell 2000 index has a barrier range, but investors are unlikely to get more than a small return, structured products analyst Suzi Hampson said.

UBS plans to price zero-coupon principal protected absolute return barrier notes due July 29, 2011 linked to the Russell 2000.

At maturity, investors will receive par plus the absolute index return, provided that the index never closes outside of a certain range during the life of the notes. The range is defined by a lower barrier at 60% to 64% of the initial index level and an upper barrier at 136% to 140% of the initial index level.

If any of the barriers is broken, investors will receive par. The exact barrier levels will be set at pricing.

Highly volatile underlying

Future Value gave the UBS note a high value rating of 9.86 out of a best possible 10, reflecting the firm's estimate of how much the investor is getting after fees and the profit margin on the underlying derivative.

But the product had a poorer performance when the firm analyzed the potential returns, getting a return rating of just 3.8 out of a best possible 10. Looking at the probable return outcomes of the product, Future Value estimated that investors have a 98.75% probability of getting a return of just 0% to 5%.

That low return probability despite the product's higher return cap of 36% to 40% can be explained by the high underlying volatility and the product's structure, Hampson explained.

"The underlying historical volatility of the product is very high, about 53%," she said. "The upper barrier is 140%, and this is a two-year product, so you've got two years to break the barrier."

The kick-out aspect of the structure also makes it riskier the closer investors are to getting the best possible payout.

"Say the index has gone up to 130% after the year," Hampson said. "Although the investor might be thinking, oh, brilliant, this is going to pay off great returns, however clearly the closer you get to the barrier the higher your chances of breaking the barrier. This sort of demonstrates how unlikely you're going to be able to get the upper end of that barrier."

The low expected return is not surprising when the product is seen in the light of other principal protected investments, Hampson added. Certificates of deposit are mostly returning yields in the low single-digits at the moment.

Different objectives

Investors who want a better chance of getting a better return may do better with an accelerated growth product, Hampson said.

One example of such a product is JPMorgan Chase & Co.'s planned zero-coupon buffered return enhanced notes due Oct. 29, 2010 linked to the Russell 2000.

At maturity, the notes will pay par plus triple any gain in the index, subject to a maximum total payout of 119% to 122% of the principal. Investors will lose 1% for every 1% that the index declines beyond 10%.

The exact return cap will be set at pricing.

The JPMorgan notes were rated poorer than the UBS product on value and risk, but its return score was better at 4.56 out of 10.

"You do have the probability of losing capital, and it's quite a high probability of about 30%, but the likelihood of getting returns over 15% is also a lot higher," Hampson said.

The accelerated product would probably be more attractive to investors who are more comfortable with risk, whereas the UBS product could do better in a comparison to other low-risk investments, she said.

"For principal protected products, if you were going to compare returns you can get, you'd compare it to cash," she said.

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