Deutsche Bank’s capped leveraged lookback notes tied to S&P 500 favor entry over exit

By Emma Trincal

New York, Jan. 25 – Deutsche Bank AG, London Branch’s 0% capped leveraged notes due Jan. 28, 2022 linked to the S&P 500 index provide for the trade a good entry point thanks to a lookback option. But investors must forgo the uncapped return and downside protection they would likely get on a five-year note, a tradeoff that suggests the investment is a tactical bet, a market participant said.

The initial index level, or the lookback level, will be the lowest closing level of the index during the period from the pricing date up to and including July 25 and will not be greater than the closing level on the pricing date, according to a 424B2 filing with the Securities and Exchange Commission.

If the final index level is greater than the lookback level, the payout at maturity will be par plus double the index gain, subject to a maximum return of 70.5%. Investors will lose 1% for every 1% decline.

Politically charged

“It’s clearly a tactical trade,” said the market participant.

The lookback feature gives investors a chance to strike the deal at a lower level than the index price at the trading date with a six-month period observed daily.

But the lookback option is also “very expensive,” he noted, adding that over a five-year term, a simple leveraged deal tied to the S&P 500 index without the lookback could be priced without a cap and a with a 25% buffer.

“The lookback is going to take most of the cost of the options. Because of this feature you end up capped plus you have no downside protection,” he said.

The investor buying the notes would have to have a strong tactical view in order to sacrifice the uncapped return and a buffer.

“It’s a political play more than anything, I’m sure,” he said.

“It’s obviously for someone who thinks we’ll have a pullback within six months.”

That view could be the result of a combination of factors, including earnings, he said. But the first 100 days of the new presidency were probably the main driver in his view.

“The client expects that things announced during the campaign might not get done, causing this market to peel off a little bit. Maybe the market expectations regarding tax cuts or deregulation will not be met. All these things could affect how the S&P trades, causing some volatility,” he said.

“And when you have a president as volatile as Donald Trump you would expect some volatility in the market.”

Another reason to make the very short-term bearish bet in the hope of lowering the cost of entry was Europe.

“What happens with Brexit? What happens with some major elections in European countries? All that will happen within that period,” he said.

Caution

Fears over a toppish market were probably not the main driver behind the lookback, he said.

“If you were concerned about high valuations, why not wait and use downside protection instead of a six-month lookback?” he asked.

“Besides, is six-month the longest stretch you would go for?”

Investors must have a very specific view in order to choose the six-month lookback over a barrier or buffer at maturity, he added.

“Regardless of the pullback, getting into a five-year with no downside protection when you’ve had a bull market for the most part since 2009, I think it’s a little risky,” he said.

Obviously investors in the deal were not “nervous about the sustainability of the bull market,” he said.

“I think the view is that after a pullback, the S&P rebounds and that five years from now, the market will be up.”

Mild bulls

One positive aspect of the pullback was the frequency of the observation, which is on a daily basis.

“If you have a flash crash, you can strike at a real low level, something you couldn’t do if the lookback was observed monthly or quarterly,” he said.

The reverse of this advantage was the high cost of a daily lookback, which probably explained the relatively long tenor.

“Most lookbacks have shorter tenors like two years. Five years is a long time,” he said.

Another advantage was to offer double-digit returns in a slow growth market as the notes would fit the expectations of mildly bullish investors.

“You’re bullish but not overly bullish. If there is a pullback the view is that the market will come back to its norm. That’s what’s been happening so far. We had last year those short corrections and each time we quickly bounced back.”

The cap – an 11.25% return on an annualized compounded basis – would be unlikely to attract strongly bullish investors.

“You have some sort of a bullish view that over the five-year period you cap out,” he said. “You don’t ask the market to go up much. Six percent a year and you’re good.

Not an RIA

The deal was probably not designed for a registered investment advisor, he said, based on the 2% fee disclosed in the prospectus.

“That’s a little too high for advisory. It’s probably a brokerage deal,” he said.

“It’s not a bad strategy. If you’re mildly bullish, if you have this politically charged tactical view, getting 11% a year makes sense.

“My concern is where the world is going to be five years from now?

“And is it worth using all the funds in this strategy to buy a lookback without protecting some of your principal at maturity?”

The cost of today

An industry source reached similar conclusions.

“It’s not widely bullish given the lack of protection and a leverage that ‘only’ gives you 11%,” he said.

He said “only” in “quotation marks,” he explained, because the structure combined a long tenor and a full downside risk.

“It doesn’t strike me as an overly compelling deal,” he added.

“I don’t know if the lookback is cheap insurance or expensive insurance.

“But if you expect a pullback in the next six months, why not strike your deal then when volatility is higher?

“You’d get a much higher cap and better terms.”

“I’d rather strike a plain-vanilla deal after something bad happens when I get a lot of volatility so I would wind up with better economics,” he said.

Deutsche Bank Securities Inc. is the agent.

The notes will settle on Jan. 30.

The Cusip number is 25152R6R9.

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