Partially protected notes make a discreet comeback amid market fears, rising yields

By Emma Trincal

New York, March 2 – Several issues of principal-protected notes have reemerged as the market turmoil began last month. Structurers said they are not surprised if only because the sentiment has shifted from complacency to caution but also because rates are up, which facilitates the pricing of those products.

The recent offerings were not technically principal-protected notes (PPNs), which guarantee 100% of principal, but instead, partially protected notes with a protection in a range of approximately 93% to 97%.

Surprisingly, not all those deals were equity offerings. A fair number of notes were based on commodities benchmarks, according to data compiled by Prospect News.

The return of fear

Most of the deals, except for a couple of commodities trades coming in late January, priced last month during the heat of the sell-off either at the beginning of the month when the market entered correction territory or later after days of rally turned into selling again.

This may not be a coincidence.

“With the recent volatility, people are concerned and they put a greater emphasis on full or partially protected notes,” said Samuel Rosenberg, managing director at Olden Lane.

While volatility spikes may not necessarily facilitate the pricing of the zero coupon bonds with embedded call options, demand for those products increases in times of turmoil, a structurer said.

“You price these products almost the opposite way you price buffered capped notes,” he said.

That’s because capped accelerated notes “sell” volatility, which generate higher premium when volatility goes up.

“Here with PPNs, people buy volatility. You start with a zero coupon, you buy the calls. That’s it.”

Still, the psychological desire to hedge when stock prices plummet offsets the disadvantage of higher option premiums. In addition, rising yields, which triggered the sell-off in the first place, gives issuers better tools to improve deal terms.

“Yields going up is probably a huge factor behind the recent reemergence of those products,” the structurer said.

“In fact rising interest rates and fear were part of the same picture last month.”

Magic number: 100

With mounting fears, principal-protection becomes attractive again, he noted.

Fully protected notes are not so different from partially protected ones, said the structurer.

“I call them PPNs just the same. What difference does it make really to lose 3% or nothing? But believe it or not, it’s a tougher sale. Investors who buy PPNs don’t want anything that doesn’t guaranty them 100%. People are very closed-minded.”

Investors, he explained, prefer buffers, which will put most of their investment at risk, rather than taking small losses for the benefit of protecting most of their money.

“People don’t like to take losses. Most people don’t have the trader’s mindset. They’d rather risk 90% than losing 5%. The 10% buffer makes them look better. I did better than my neighbor. That’s what matters to many investors and advisers,” he said.

“You buy a car, you buy insurance. Why not do the same with your money?

“I’ve always been a big proponent of these 95% or 97% principal protected deals,” the structurer said.

“I’m applauding if the market is bringing them back. It should do these deals. Allow these losses. Let the market work for you. You’ve lost 2.5%? Big deal! You get almost all of your money back. And if the market recovers you can benefit from it. It’s not a stop loss. You can afford to wait.”

Investors may not like those notes for different reasons, according to advisors pointing to the tax treatment of principal protection, which forces investors to pay ordinary income each year even though they are not receiving interest.

“That’s one reason why people don’t do it but not the main one... You can always put it in a retirement account,” the structurer said.

“No, the main reason is that for most people 100 is the magic number.”

Equity deals

On the equity side, Prospect News identified the following deals.

Morgan Stanley Finance LLC priced $6.77 million of 0% equity-linked partial principal at risk securities due Feb. 5, 2021 linked to the Euro Stoxx 50 index. The payout at maturity will be par of $1,000 plus 110% of any index gain.

If the index declines, investors will receive par plus the index return, subject to a minimum payout of $975 per security.

Morgan Stanley Finance LLC sold a smaller deal for $1.47 million of 0% equity-linked partial principal at risk securities due Feb. 4, 2021 linked to the Euro Stoxx 50 index.

The payout at maturity will be par plus any index gain, up to a maximum return of 98%.

If the index falls, the payout will be par plus the return, with a minimum payout of 97.5% of par.

Morgan Stanley distributed on the behalf of Barclays Bank plc $3.02 million of 0% market-linked notes due March 3, 2021 linked to the Euro Stoxx 50 index.

The payout at maturity will be par plus 160% times any index gain.

If the index falls, investors will be exposed to the loss, subject to a 90% minimum return.

Separately, Citigroup Global Markets Holdings Inc. priced $4.48 million of 0% market-linked notes due Feb. 11, 2021 linked to a weighted basket of three indexes.

The basket consists of the Euro Stoxx 50 index, the S&P 500 index and the Nikkei 225 index, equally weighted.

The payout at maturity will be par plus 100% of any basket gain, up to a maximum return of 40%.

If the basket falls, the payout will be par plus the return with a minimum payout of 93% of par.

Finally, JPMorgan sold on the behalf of Barclays Bank a $3.5 million issue of 0% notes due Feb. 16, 2021 linked to the Euro Stoxx 50 index

The payout at maturity will be par plus 1.07 times any index gain.

If the index falls, the payout will be par plus the return, with a minimum payout of $975 per $1,000 principal amount.

Commodities transactions

JPMorgan distributed last month several commodities-linked notes with partial principal protection. Their structure, slightly different from those seen with the equity underliers, were however consistent within that group.

All the following commodities trades have for placement agents JPMorgan Chase Bank, NA and J.P. Morgan Securities LLC. The majority of them were issued by Deutsche Bank. All deals were linked to the same benchmark.

Deutsche Bank AG, London Branch priced $5.12 million due Jan. 30, 2020 linked to the Bloomberg Commodity index.

The payout at maturity will be 96.14% of par plus any index gain. If the index finishes flat or falls, the payout will be 96.14% of par. Investors will receive a positive return only if the index gains by at least 3.59%, but investors will receive at least 96.14% of par at maturity.

Deutsche Bank AG, London Branch priced another similar deal for $5 million maturing Feb. 21, 2020 linked to the Bloomberg Commodity index.

The payout at maturity will be 95.91% of par plus any index gain. If the index finishes flat or falls, the payout will be 95.91% of par. Investors will receive a positive return only if the index gains by at least 4.09%, but investors will receive at least 95.91% of par at maturity.

Deutsche Bank AG, London Branch’s $2 million of 0% notes due Feb. 21, 2020 linked to the Bloomberg Commodity index offers a payout at maturity of 95.91% of par plus any index gain. If the index finishes flat or falls, the payout will be 95.91% of par. Investors will receive a positive return only if the index gains by at least 4.09%, but investors will receive at least 95.91% of par at maturity.

Deutsche Bank AG, London Branch priced another $2 million deal with notes also due Feb. 21, 2020 and linked to the same index. The payout will be 96.05% of par. Investors will receive a positive return only if the index gains by at least 3.95%, but investors will receive at least 96.05% of par at maturity.

Finally, JPMorgan’s subsidiary issued a similar deal. It was JPMorgan Chase Financial Co. LLC’s $1 million of 0% notes due Jan. 30, 2020 linked to the Bloomberg Commodity index.

The payout at maturity will be 96.8% of par plus an additional amount. The additional amount is equal to the index return, subject to a floor of zero. Investors will receive a positive return only if the index gains by at least 3.2%, but investors will receive at least 96.8% of par at maturity.

Striking it differently

The structurer compared the structures of the equity deals with their commodity counterparts, noticing a slight variance.

“They just used different strikes,” he said.

He took the following example to analyze the structure common to the commodities deals: 96% of principal guaranteed and the need for investors to see a 4% increase in the underlying in order to begin pocketing gains.

“You have a 96 zero that guarantees you 96% of principal. But you buy the calls at-the-money, or at 100 if you will. If nothing happens, if your index stays flat at 100, you’ll lose 4. You need the option to be up 4% to make you whole and break-even.”

A call is at-the-money when the initial price of 100 is identical to the strike price.

The strike price is different with the equity offerings, he continued.

He used the same example, simply changing the strike price to explain how the payoff worked with the equity pricing.

“This time you buy in-the-money calls at a strike of 96. If the market stays the same, you’re in the money. You’ve already booked your 4%.”

The call option is in-the-money because the initial price of 100 is greater than the 96 strike.

“These are minor differences. They probably had to do the commodities deals this way to make the pricing work,” he said.

The commodities-linked notes are shorter. They carry a two-year maturity versus three years for the equities.

“Here you go. It makes sense. The longer the tenor, the better the terms look in general,” he said.

© 2015 Prospect News.
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