Deutsche Bank’s 3X leveraged notes tied to Facebook offer quasi binary return for bulls

By Emma Trincal

New York, Sept. 8 – Deutsche Bank AG, London Branch’s 0% Accelerated Return Notes due September 2018 linked to Facebook, Inc. stock offer similarities with digital notes as the chances of getting paid the maximum amount are high, said Suzi Hampson, structured products analyst at Future Value Consultants. As the product offers no downside protection, the notes are primarily designed for bullish investors.

The payout at maturity will be par plus triple any stock gain, up to a maximum return of 15% to 19%. The exact cap will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

High gear

“When a product is highly leveraged like this one, the return looks more binary than you would imagine,” she said.

“You’re more likely to hit your cap, and therefore it’s very similar to a digital although not quite the same.”

Future Value Consultants offers stress test reports on structured products. Its clients can choose any combination of the 29 tables or sections featured in each report depending on the focus of their analysis as well as the product type.

To run the report on this product, Hampson used the 17% hypothetical cap at the mid-point of the range.

“You have a pretty high leverage here and no downside protection. You are more likely to either lose money or hit the cap. What happens in between – getting a positive return lower than the cap – is one of the less likely outcomes,” she said.

Either or

She used the investor scorecard table, one of the report’s tables, to illustrate her comments.

The scorecard is made up of different mutually exclusive outcomes of product performance, displaying probability of occurrence and average returns.

For this leveraged capped structure the outcomes are limited to three: maximum return (the payout is the cap), positive return (there is a gain but it is below the cap) and capital loss.

In a neutral market scenario, investors have about 41% chances of receiving the maximum return. There is only a 9% probability of getting a positive return below the 17% cap. On the other hand, the odds of losing money are 50%.

“If you invest in this product you have very high chances of getting the maximum return but the chances of losing are very high too,” she said.

“It’s easy to get to the cap because of the high gearing. You don’t need that much growth in the stock to get to the maximum return.”

The underlying stock needs to rise by 5.65% a year in order for the note to provide the 17% maximum return.

For that stock, which is already up nearly 50% for the year to date, this type of growth may be easily achievable in an upward market. The implied volatility of Facebook is 24.72%.

Projection scenarios

However, a look at the neutral scenario alone is not sufficient, she said.

“The neutral assumption doesn’t give you the full picture.

“It’s the standard pricing scenario based on the risk-free rate minus the dividend.”

The neutral scenario can be used as a comparison tool not so much for projections.

“You can compare this note with another one that offers a barrier for instance. If you’re interested in assessing the value of a specific term the base-case will facilitate comparisons between products,” she said.

To run projections, investors use four market scenarios, which are part of the simulation and are included in each report. Those four market assumptions are: bull, bear, less volatile, more volatile.

“If you’re going to invest in this product you would be looking for a bull scenario,” she said.

Yet even the bull assumption is quite “muted,” which is part of the firm’s methodology as it uses conservative growth rates for its simulations on purpose.

For instance the bull scenario in the report is based on an annualized growth rate of 8.5% for the underlying stock.

“While this growth rate is very conservative it still gives you a more realistic picture of what you might expect,” she said.

The probability of the three outcomes for all market scenarios are shown in a separate table, called capital performance tests.

In there, the bull scenario reveals chances of gains versus losses of 61% and 39% respectively.

The cap is reached 52% of the time in the bull scenario.

Payoff

The average payoff by outcome is described in the capital performance section. It shows an average gain of 15.8% under the bull assumption. The average amount of loss is 16.3% under this scenario.

“This shows the impact of having no barrier or buffer,” she said.

“The average loss amount may seem high. But you still have a 61% chance of getting a positive return.”

The highly leveraged note should give investors a higher payout than they would receive with a digital note, she said, comparing the two structures in general.

“If you had a digital product kicking in above 100 you would have presumably a lower payout because you would have more chances of getting it. So your return would be a little bit lower,” she said.

“With this, a 2% price increase will only give you 6% whereas in a digital product, 2% will give you the maximum...any price increase would give you the maximum regardless of its magnitude.”

Particular type of bull

Investors who may consider the notes would have to be mildly bullish, she said.

“It’s not quite designed for the super bullish. If you are very bullish you don’t want a cap. But if you think the stock has already had a good run and is likely to go up at a much lower pace, this is a way to achieve better returns,” she said.

The notes are not for everyone. Having no downside protection is an important consideration, she added.

“The cap is still quite high and you don’t have any downside protection.

“It’s definitely a bullish play for someone who is happy to take the cap and not too concerned about the downside.

“This is a typical high-risk, high-return product.”

BofA Merrill Lynch is the agent.

The notes will price and settle in September.

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