Barclays' $121.61 million STEP Income notes on Ford drew top bid for return enhancement, yield

By Emma Trincal

New York, April 17 - Barclays Bank plc's $121.61 million of 8% STEP Income Securities due May 23, 2014 linked to Ford Motor Co. stock saw high demand given the yield enhancement features of the structure, sources said. It was last week's top offering.

The notes offer a fixed interest rate of 8% payable quarterly along with a contingent step payment of 7.52% if the stock finishes at or above a step level set at 108% of the initial price, according to a 424B2 filing with the Securities and Exchange Commission.

Investors are getting paid 8% regardless of the stock performance for the 13-month period. If the stock gains 8% over the term, the product generates a 15.52% return, which is the sum of the coupon and the step payment, according to the prospectus. A decline of Ford shares below the initial price exposes investors to any losses.

Investors are capped at about 15%, but any stock gains within that range offer investors a chance to outperform the reference asset excluding dividends, sources noted.

Market timing

"It's a nice structure. People probably liked it for the return enhancement on the upside and the slight cushion provided by the 8% coupon on the downside," said Marc Gerstein, research consultant at Portfolio 123.

If the stock ends positive but below the step level, investors could outperform the share price, he said. In the range between the step level and the sum of the two payments (at about 15%), the structure also enables noteholders to outperform the stock excluding dividends.

"I would be hard-pressed to look at it as a fixed-income equivalent. It's more equity than fixed income, but you do have the interest rate, so I guess it's kind of a hybrid," Gerstein said.

"It's not bad. I like the cushion you get on the downside from your coupon and the fact that you can outperform the stock on the upside within a certain range.

"But it's not something I would be doing because of the market. We're on the verge of a market correction that could overshoot the 8% on the downside. The product is attractive, but I wouldn't do it today. It's just a matter of not a great timing."

Bullish structure

A market participant said that the structure is interesting as it offers two levels of return depending on how much higher the final share price is than the initial price.

"It looks like I'm selling an at-the-money call. But for a 13 months, I could get a better price than 8% if all I was doing was selling a call," this market participant said.

"But the note offers something beyond this because if the stock goes above the 8% level, there's an additional coupon offered, which gives me a total return of 15.5%."

The product is less attractive for defensive investors, he said.

"I'm not a big fan of structures that lack any kind of downside protection. Getting the protection should be the primary reason for investing in structured notes. These products I think are more appropriate as risk management tools than for the purpose of leveraging or enhancing the upside. I guess I'm more of a conservative.

"Now, you could look at the coupon as a form of buffer. You can look at this note as some form of reverse convertible since you're selling volatility here. But I think that at 8%, you're selling it relatively cheap.

"However, the relatively small coupon on this stock is justified by the additional kicker if the stock is above 8%."

Selling calls

The market participant said that structuring the two types of coupons - the fixed interest rate at 8% and the contingent step payment of 7.52% - could have been done in a variety of ways.

"One possibility is that because the at-the-money call generates more than 8%, they were able to afford selling fewer of those calls," he said.

"They were either short a put or long the stock. In capturing the dividend stream of the stock along with the discount they're getting on the call, they were able to offer the 7.5% contingent coupon."

The issuer could have been simply selling a fraction of the at-the-money call, he explained.

"If you sold one call option, the premium would be significantly more than 8%. As a way to insure against the potential of having to pay the additional premium, they may have just sold a fraction of the call," he said.

"I think they're probably long the stock instead of short a put. If the stock rallies, they have the appreciation potential of the shares plus the dividend stream to potentially hedge against the liability of having to make the extra payment.

"Say they're long 1,000 shares. Normally you would have to sell 10 calls, but instead they would sell only eight calls. It's just an example."

An option contract represents 100 shares of stock, which is why a call on 1,000 shares would require only 10 option contracts.

"By not paying you the full premium of the at-the-money option up front, they're giving you the potential to make that up if and only if the stock finishes above the 8%.

"For instance they may sell 0.8 at-the-money calls and sell 0.2 options with a strike at 108. They're just selling a smaller fraction of out-of-the money calls.

"That way, not only can they pay you the 8% guaranteed, it gives them enough room to pay you the additional coupon if the stock hits the higher strike."

The notes (Cusip: 06742C491) priced April 11.

BofA Merrill Lynch was the agent.

The fee was 1.75%.

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