Barclays’ capped leveraged notes linked to real estate index represent big sacrifice in yield

By Emma Trincal

New York, Aug. 29 – Barclays Bank plc’s 0% capped Leveraged Index Return Notes due September 2018 linked to the Dow Jones U.S. Real Estate index offer attractive terms, but the non-payment of dividends reduces the appeal of the notes, buysiders said.

If the index return is positive, the payout at maturity will be par of $10 plus 200% of the index return, subject to a maximum return that is expected to be 17.5% to 21.5% and will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

The cap would be 8.5% to 10.25% per year on a compounded basis.

Investors will receive par if the index declines by 10% or less and will lose 1% for every 1% that it may decline beyond 10%.

8% opportunity cost

Investors in the notes are not entitled to receive dividend payments, which is the case with the majority of structured products.

“You’re giving up almost 4% a year in dividends. I am always wary to give up that much yield because historically, it’s a big percentage of the return,” said Jerrod Dawson, director of investment research at Quest Capital Management.

The Dow Jones U.S. Real Estate index has a 3.8% dividend yield.

Bull market

The index has shown a strong performance, up 10% so far this year and nearly 15% over the past year.

“If it didn’t have a cap or if the cap was higher, I would be warmer to it,” he said.

The bullish performance of the index is mostly the result of investors’ hunt for higher interest rates, he said.

“People are looking for yield wherever they can find it in this environment.”

The asset class, he noted, is very interest-rate sensitive.

“A lot of the underlying stocks use leverage to borrow money to buy property. It works as long as cash flow is coming in.”

Too rich

Dawson, however, downplayed the interest rate risk, showing more concern about current valuations.

“I don’t personally think rates are going to rise very quickly, but the sector is pretty rich. It kind of skews the cap and buffer dynamic.”

The 9% to 10% maximum return on the notes does not adequately compensate investors for the risk they are taking, he said.

The iShares U.S. Dow Jones U.S. Real Estate exchange-traded fund, which replicates the performance of the index, is currently trading at $82.50, close to its all-time closing high of $85.25 in March 2007.

“It’s very expensive at this point, and you’re giving up too much of the steady dividends. I would buy it outright instead.”

Rather than interest rate risk, Dawson paid closer attention to the “cyclicality” of the index’s sector.

“REITs are interest-rate sensitive, but they’re also very recession-sensitive. Should we see an economic slowdown – and we may – the sector would be hit pretty hard.”

Interest rates

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said he is bullish on real estate but not necessarily “excited” about the notes.

“A lot of the REITs are based on income generation. Our current low interest rates environment helps the sector,” he said.

REITs, he added, use a lot of financial leverage by borrowing against their fixed assets.

As a result, lower interest rates help in two ways: “They lower the cost of borrowing, and it also drives up the cost of existing properties,” he said.

Kalscheur does not expect rates to go up very much in the United States any time soon.

“As long as rates don’t increase too much, the conditions to invest in this market remain bullish,” he said.

Two years

Kalscheur said that the notes have positive characteristics but that they would not meet his investment criteria.

To begin with, Kalscheur said that he prefers longer-dated notes.

“We’re not as concerned about length. I know a lot of people are. ... When they see a short duration, they look at it as a benefit. For us it’s the opposite. We tend to lean toward the longer term. We think it helps mitigate downside risk, and obviously you can get much better terms,” he said.

“I’m bullish on REITs. The cap isn’t bad here. You can get a 9% to 10% rate of return. But I’d rather have a four-year uncapped than a two-year capped.”

Real buffer

The opportunity cost represented by 7.6% of unpaid dividends is perhaps worse in his view.

“You get good terms in these notes, but you would hope so! You’d better get good terms when you’re giving up almost 8% in yield. That’s a big sacrifice,” he said.

The 10% buffer at first glance “looked nice,” but in reality, investors only have a 2.4% real protection, measured as the difference between the 10% buffer size and the unpaid dividends.

“One could argue that I could buy the index directly and have a 7.6% protection, just like a buffer. I have unlimited upside, but I don’t have the leverage,” he said.

“Maybe that’s a wash ... depending on how bullish I am.

“If I think the return is going to be up more than 21%, the notes make no sense.”

Fee

The cost of the investment, however, is satisfactory. For retail accounts, the fee is 2%, but it drops to 1.5% for accounts of more than $5 million, according to the prospectus.

“It’s good to know that they’re giving institutional investors a discount,” he said.

The 1.5% institutional fee for two years, or 75 basis points a year, is “acceptable,” in his view.

“Look, this is not a bad offering. The terms are good, but they’re not exactly the terms that I want.

“If I had to design the product myself, I would lengthen the maturity and eliminate the cap.”

But that would not be enough.

“My biggest sticking point is that you’re giving up so much in yield, your real buffer is only 2.4%,” he said.

“The dividend yield is almost double what it is on the S&P. That changes the whole conversation.”

BofA Merrill Lynch is the underwriter.

The notes will price in September and settle in October.

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