Deutsche's escalator notes use structure that faded in years of volatile markets, analyst says

By Kenneth Lim

Boston, Aug. 15 - Deutsche Bank AG's escalator notes linked to a basket of cross-asset indexes recalls a structure that fell out of favor when markets were doing well, structured product analyst Tim Mortimer of Future Value Consultants said.

Meanwhile, Barclays Bank plc's reverse convertible linked to common stock of Yahoo! Inc. demonstrates how generous barriers are usually accompanied by high risks, Mortimer said.

Deutsche Bank plans to price 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.

Deutsche Bank Securities Inc. and Deutsche Bank Trust Co. Americas are the agents.

The Balanced Currency Harvest index reflects the value of notional long and short three-month foreign exchange forward positions in specified 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.

Structure struggled in bull markets

The escalator feature emerged in the United Kingdom about 10 years ago, Mortimer recalled.

"I certainly recognize the structure," he said. "It's a ladder structure...A ladder can have more rungs, and in this case there's three of them, and you get the higher of the final level and the best rung. So you can keep putting rungs into the ladder structure and each one that you add makes it more valuable."

But the feature fell out of favor as volatility increased and markets improved, Mortimer said. The key problem was that when hedging the structure became more expensive, issuers found it more difficult to offer terms that appealed to investors. Point-to-point products that offered better participation rates looked comparably better, he said.

"When volatility increases, it's harder to give attractive terms," he said.

But Deutsche Bank may have found a way to make the structure work by creating a basket with components that have relatively low correlations between one another, Mortimer said.

"It's one-third currency, one-third commodities, one-third equities," he said. "There's quite low correlation between the three asset classes, so the volatility of the basket is going to be quite low, actually. That's why it prices OK. It wouldn't work if it was just equities."

Mortimer said the product appears to be a decent investment opportunity.

"The lock-in level, it's a big plus," he said.

Barclays note seems risky

Mortimer also noted that a recent Barclays reverse convertible linked to Yahoo! common stock has a high risk profile along with a generous barrier level.

Barclays plans to price 14.5% reverse convertible notes due Feb. 27, 2009 linked to Yahoo! Inc. shares.

The payout at maturity will be par in cash unless Yahoo shares fall below 70% of the initial price during the life of the notes and finish below the initial price, in which case the payout will be a number of Yahoo shares equal to $1,000 divided by the initial price.

Future Value rated the product 3.99 out of a maximum of 10 points, in a report by the research firm.

"The income level offered is well above the risk-free rate which is due to the risk to the principal amount which would be caused by sufficient stock underperformance," Future Value stated in the report.

The Barclays note is an example of why investors should understand that products with attractive terms are usually also accompanied by high underlying volatility, Mortimer said.

"Even with the barrier at 70% ... yet the risk is still quite high," he said. "The [six-month underlying] volatility is about 64%, so...it's a general warning that a reverse convertible on a single stock can be quite risky. You might think a barrier of 70% is pretty cast iron."

The high volatility of products like the Barclays note does not mean that they are poor investments, Mortimer said. Rather, they highlight the importance of good research before making an investment.

"If you put the barrier very low, you're going to take some from the coupon and take away much from the value of the product," he said. "If you pick your products and your stocks judicially, in most cases you can pick up that coupon without losing your principal."

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