Bank of the West to price a pair of basket CDs aimed at different breeds of income-seekers

By Emma Trincal

New York, July 6 – Bank of the West is prepping a duo of quasi identical certificates of deposit that offer access to an either high or low coupon based on the underlying basket performance, according to two term sheets.

The only difference between the two CDs is the coupon levels, which are designed for slightly different income objectives.

“We haven’t seen those high/low coupons for a while, but this structure has been done before,” a market participant said.

What is less common though is the payout formula used to kick off the higher coupon.

Both products named “income advantage CDs” use a worst-of feature to determine which of the two coupons will be paid, something not often seen with high/low yield notes. Worst-of features are most often used to trigger the payment of a unique coupon payable on a contingent basis.

Almost perfect twins

Common terms for both structured CDs include the following:

• A maturity date of July 28, 2025;

• The same underlying basket, which is composed of the stocks of Apple Inc., AT&T Inc., Ford Motor Co., Pfizer Inc. and Southern Co.;

• A set of two coupons: the minimum interest rate (or lower coupon) and the performance-based interest rate, which is the higher potential interest rate;

• Interest is determined and paid on an annual basis. The minimum interest rate is guaranteed;

• The performance-based rate will replace the lower coupon if all stocks on the relevant annual valuation date close at or above their initial share price. If not, investors receive the minimum coupon; and

• The payout at maturity is par.

Lower low, higher high

The set of rates varies between the two upcoming deals. This was the only difference between the two products.

In the first CD (Cusip: 06426XQZ6) investors get a lower minimum rate of 0.15%, and the higher performance rate is 7.15%, according to one of the term sheets.

In the second one (Cusip: 06426XRA0) the guaranteed coupon is higher at 0.50%, but the performance-based interest rate is lower than in the other deal at 4%.

“The difference reflects different needs for investors,” the market participant said.

“In both cases they insist on getting a little bit of something. Is there really a big difference between 0.15% and nothing? Not really, but this goes to show how much people crave yield. It’s also partly psychological.”

Still, being able to collect a guaranteed coupon while getting a chance to earn much more makes the structure appealing compared to a mere money market account, he noted.

“People may worry about negative interest rates, although I don’t think so. I don’t think we’re heading in that direction. But people want something above zero. That’s for sure,” he added.

Risk component

The difference between 7.15% and 4% represents more than three percentage points, he noted, comparing the two performance-based rates.

By giving up these 3.15% of potentially higher returns investors are only securing 35 basis points more in minimum rate.

“If you look at it that way – I’m giving up 3.15% to keep 35 bps – it looks totally stupid. But it’s not. You can’t look at it that way,” he said.

“You have to look at it from a pricing perspective.”

To make his point, he considered the seven-year swap rate, which is 1.1%.

Investors receiving the 0.15% minimum rate are risking 95 basis points compared with what they could obtain with the swap, he explained.

Separately, those getting 0.50% guaranteed are only risking 60 bps versus the swap rate.

By risking 95 bps instead of 60 bps, investors are compensated with the higher coupon, he said.

“You have to look at it from the risk perspective. That’s the correct way to understand the gap between the 4% and 7.15% rate and why one guy gets a higher coupon than the other. It doesn’t mean one is stupid and the other is not. It’s just pricing,” he said.

Principal protection

Both deals should appeal to yield-seeking investors who feel uncomfortable risking principal. That is the advantage of a CD wrapper, he said.

“Rates are so low right now. People take all kinds of risk to get some decent yield. You see a lot of worst-of notes among principal-at-risk notes.

“The use of a worst of here in a CD is a positive. I think it’s healthy that they would try to use this type of structure that’s used in notes.

“For conservative investors, it’s not bad. You might get 7%. It’s unlikely that you would get it seven years in a row, but at least there’s a chance to get it once or more.

“You may only get 15 bps, but at least your principal is safe.”

Above zero, below zero

Paul Weisbruch, vice president of options sales and trading at Street One Financial, said the continued decline in interest rates helps explain the appeal of guaranteed coupon, albeit small ones.

“It may be driven by the fear of negative interest rates. You would do better with 15 bps than with a sovereign German bond in negative territory,” he said.

“The fact that several countries have already adopted negative interest rates may be pushing people to products like that.”

Credit risk mitigation

The search for yield is visible in every corner of the market.

“Look at high yields. People got killed when oil prices dropped earlier this year. All of a sudden a lot of oil drillers went out of business. That’s one of the main issues you have with high yields. At least with this, credit risk exposure is limited,” he said.

Investors in the CDs incur credit risk but only above a certain threshold. The Federal Deposit Insurance Corp. insures up to $250,000 against default. Credit risk exposure only applies to amounts in excess of this statutory limit, according to the term sheets.

Weisbruch added that the underlying basket is attractive.

“I like the specific names in the basket. You get a good balance between growth and yield. People don’t think dividends when they buy Apple. They think growth. But you have utilities companies in there with some good yield,” he said.

Both CDs will price on July 25 and settle on July 28.

BNP Paribas Securities Corp. is the common agent.

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