Deutsche Bank’s high, low digital notes on banking, energy funds show deep barrier

By Emma Trincal

New York, Oct. 25 – Deutsche Bank AG, London Branch’s 0% digital return notes due Oct. 28, 2021 linked to the lesser performing of the SPDR S&P Regional Banking exchange-traded fund and the Energy Select Sector SPDR fund give investors a chance to hedge the risk associated with the two sectors. The low correlation between the funds makes for a riskier product, but the barrier appears very strong, according to sources.

If each fund finishes at or above its initial level, the payout at maturity will be par plus the high digital return of 42% to 48%, according to a 424B2 filing with the Securities and Exchange Commission.

If either fund falls but finishes at or above its 60% barrier level, the payout at maturity will be par plus the low digital return of 10%.

Otherwise, investors will be fully exposed to any losses of the worse performing fund.

Assess the barrier

“I haven’t seen this kind of double digital before with a high and a low. It’s kind of unique. Also you don’t typically see regional banks and energy married together in a note format,” said a financial adviser.

The downside risk was the main concern.

“Can any of those two funds breach that barrier even though 40% is a pretty healthy barrier? That’s what you need to ask yourself first,” he said.

“The energy sector is down this year and so it may be a good time for buying.”

The Energy Select Sector SPDR fund is down 18% this year.

The SPDR S&P Regional Banking ETF is relatively flat for the year. But its share price has increased by 4.25% in the past month.

“The probability of breaching in either one of those funds is probably pretty slim,” he said.

Income replacement

Investors need also to be comfortable with the capped upside, which is in the neighborhood of 10% a year on a compounded basis for the high coupon and 2% for the low, he explained.

“Obviously you’re not too bullish. A 10% annual return is probably what you could expect over that period of time on these indices,” he said.

“For that reason and given the size of the barrier, I see it more like an income play.”

The two digital levels make the notes distinct from a typical fixed-income replacement. But it adds value as a hedge, he said.

“Depending on the coupon you get, whether it’s the high or the low, you’re going to be happy or sad.

“Although one could argue that getting 10% in four years if the index is down 35% would not be a sad thing.

“It might also be used as a way of hedging your portfolio.”

Low correlation

A risk factor investors should take into consideration with a worst-of is naturally the correlation between the two underliers, said a market participant.

“The correlation between the two ETFs is not very high. You’re talking energy and regional bank stocks. So there’s a pretty decent risk of one of these things moving in the wrong direction,” he said.

“It increases the likelihood that one would breach the barrier, although 40% seems like a pretty good barrier.”

The coefficient of correlation between the two ETFs is 0.35 with 1 being perfect correlation.

Volatility

While the energy ETF has recovered last year some of the losses it incurred during an 18-month bear market, which started in the early summer of 2014, the trend has been downward for most of the year.

Certainly the 40% level can be breached, he noted. The share price of the ETF dropped 46% between June 2014 and Jan. 2016.

“To make sense you need to be bullish on both sectors. If it’s up, you’re getting the let’s say 44% return. If it’s down by less than 40%, you get that 10%, which is barely where Treasuries are but at least you’re getting something.

“You just want to stay in that range. That means being mildly positive on both sectors.”

JPMorgan Chase Bank, NA and J.P. Morgan Securities LLC are the agents.

The notes will price on Oct. 25.

The Cusip number is 25155MEY3.

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