Barclays' CMS steepener, Russell 2000-linked notes offer high yield, but principal is at risk

By Emma Trincal

New York, April 23 - Barclays Bank plc's principal-at-risk callable CMS steepener and Russell 2000 index-linked notes due May 14, 2029 are designed for investors seeking competitive yields, but they are in return exposed to market risk in addition to the usual issuer's credit risk, sources said.

The interest rate is 11% for the first year. Beginning May 14, 2015, the interest rate will be four times the spread of the 30-year Constant Maturity Swap rate over the two-year CMS rate, subject to a minimum rate of zero and a maximum rate of 11% per year. Interest is payable quarterly, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par unless the final index level is less than 50% of the initial level, in which case investors will lose 1% for every 1% that the final index level is less than the initial level.

Beginning May 14, 2015, the notes will be callable at par on any interest payment date.

Yield quest

"It's interesting. Most steepeners are principal-protected. Here, principal is at risk, but the barrier is observed at maturity and it's a 50% level," a market participant said.

"It's definitely designed as a high-yield alternative, and whenever you buy anything high-yield, you should expect more risk. This is not a Treasury. It gives you a much better return and therefore, there is more risk.

"In a way, it's a little bit like getting a high-yield bond. The risk is not so much on the credit side. Barclays, an investment-grade issuer, is not very likely to default. Here you're getting the really high coupon of 11%. In the worst-case scenario, if the market crashes down 50%, your principal is at risk, just like it would be for a high-yield bond. You're not taking a specific issuer risk, but you're exposed to the risk of a market correction."

Steepeners

Steepeners are a bet on a steeper shape of the yield curve.

Most of the time, the payout is based on a spread between two points on the curve, with or without leverage, and the principal is guaranteed at maturity. CMS deals are usually callable, which introduces more risk to the investor but results in higher coupons.

This deal, however, is different: the final level of an equity benchmark introduces market risk with a potential loss of 100% of principal, according to the prospectus.

These rate-based products with an equity component are not uncommon, a sellsider said.

"They come up with these deals every month, either Barclays or Morgan Stanley," he said.

"The barrier introduces more risk, and from what I've seen, people prefer the S&P more than the Russell.

"We saw Morgan Stanley last month showing something similar but on the S&P."

He was referring to Morgan Stanley's $30 million of fixed-to-floating leveraged CMS curve and S&P 500 index-linked notes due March 31, 2034. This offering has a fixed rate of 10% for the first four years, with a cap of the same amount during the remaining years. After the initial four years, the floater is based on the same spread of four times the 30-year CMS rate minus the two-year CMS rate. The final barrier is also 50%.

Tenor, market risk

The sellsider said that investors feel somewhat comfortable with the combination of low barriers and long-dated notes.

"If you look at the past 40 years, the worst 15-year period of the S&P 500 resulted in a positive return of 38%. And that's the worst of all the 15-year periods," he said.

"With that kind of stats and on a 15-year time horizon, you can feel pretty comfortable that a 50% downside is OK.

"Now this is the Russell 2000, which is more volatile than the S&P 500. But still, I think 50% is a pretty good threshold over that 15-year timeframe."

But the market participant said that time can be deceiving as a buffer against losses.

"The observation is at maturity. So you have 15 years to produce this 50% decline. But just because there is more time in a 15 years than in a three years should not make you assume that it's less risky," he said.

"Intuitively, buysiders tend to believe that the market is much less likely to crash over a longer period of time than over a couple of years. But I don't know if it's true. It's an intuitive concept justified by historical data. But if you look at it mathematically and price the options, there is a sufficient probability showing that the issuer is willing to pay you a high coupon to take on that risk.

"Intuitively, it feels like 15 years is low risk. Realistically, it's not less risky.

"That's why these deals work. They satisfy both the issuer and the investor. The issuer is willing to pay up a higher coupon, and you're willing to take on the bet because intuitively, it feels OK."

Impossible call

Tony Romero, co-founder and managing partner of Suncoast Capital Group, agreed.

"In terms of the interest payment, worst-case scenario you get only 11% and you're called early," he said.

"Assuming you're not called, you could lose all your investment.

"How can anybody have possibly any idea of what the Russell 2000 will be in 15 years from now and interest rates over the next 15 years?

"If the 50% barrier is hit at maturity, you may get extra protection from the 11% you would have collected on the first year and additional interests at an unknown rate. But this is still pretty risky."

Low liquidity

Liquidity in relation to price is also a concern, he said.

"The issuer gets paid a 5% fee up front on the settlement date. If you on the other hand wanted to sell your note during the term, I doubt that you would get anything close to par. You're certainly not going to sell this note at a premium. Who wants to pay a premium with a call feature? You would have to understand that you are not going to have a lot of liquidity," he said.

Barclays is the agent.

The notes will price May 9 and settle May 14.

The Cusip number is 06741UCT9.

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