Barclays' 8.35%-9% autocallable yield notes tied to Russell 2000, fund show more risks

By Emma Trincal

New York, Dec. 14 - Barclays Bank plc's 8.35% to 9% autocallable yield notes due Dec. 24, 2013 linked to the Russell 2000 index and the iShares FTSE China 25 index fund bring a higher level of risk and other risks than comparable products partly due to the worst of feature, said Suzi Hampson, structured products analyst at Future Value Consultants.

The notes will be called automatically at par plus accrued interest if both components close at or above their initial level on three call valuation dates, which are March 19, June 19, 2013 and Sept. 19, 2013, according to a 424B2 filing with the Securities and Exchange Commission.

Interest is payable monthly.

A knock-in event will occur if either component falls below the knock-in level, 80% of the initial level, on any trading day.

If a knock-in event does not occur or if it does and the return of the least-performing component is zero or positive, investors will receive par at maturity.

If a knock-in event occurs and the return of the least-performing component is negative, investors will share in those losses.

Hybrid

Hampson said that the product fits into a hybrid category.

"It's a combination of an autocallable and a reverse convertible.

"One of the common characteristics is the fixed income, which you also get in a reverse convertible regardless of the performance of the underlying.

"But unlike the typical reverse convertible, this one is callable so you don't know in advance what your final return is going to be because the duration of your product is not fixed," she said.

The impact of the call feature on risk is mixed, she said.

"The quarterly call date generates reinvestment risk that you typically wouldn't have with the traditional non-callable reverse convertible," she said.

"On the other hand, the call gives you the opportunity to get your capital back, which in theory should make those products less risky," she said.

The structure is organized around two types of barriers, she said. One, at the initial price and observable quarterly, triggers the call. The option to be exercised requires that the conditions be met by both underlying components, not just one, she noted.

The other barrier, she said, at a lower strike of 80% is the knock-in, observable any day, which will determine the amount of principal to be paid back at maturity. It only take one underlie to breach this barrier, she said.

Hampson compared the product's risk with others in the same callable reverse convertible category, using Future Value Consultants' riskmap.

Risk

The riskmap measures risk on a scale of zero to 10, with 10 being the highest risk level. The score is calculated by adding two risk components: market risk and credit risk.

At 4.96, this product's riskmap is higher than the 3.28 average for the same product type.

Most of the risk derives from the market risk component, she said.

"This product is more risky than the average partly because of the worst of feature. You have two underlyings and your principal is at risk, based on the worst performance of the two," she said.

In a worst of structure, the greater the correlation between the two underlyings, the lower the risk, she explained.

"That's because the chances of having one of the underlying assets behave differently than the other are reduced. Inversely, little or no correlation between the two underlyings will significantly increase the risk. And that's what we have here," she said.

The correlation between the Russell 2000 index and the iShares FTSE China 25 index fund is 32%.

"That's not much if you compare the correlation between the FTSE 100 and the S&P 500 for instance, which is 90%," she said.

The combination of the low correlation and the barrier characteristics contributed to amplify the risk, she said.

"Because this product shows a weak correlation between the two underlyings, your chances of kicking out are smaller and the odds of breaching the barrier are greater. That's simply because both underlyings have to be above the 100% trigger on a quarterly basis to get called while it only takes one to get knocked-in at any time," she said.

Complexity, although not simply measured, also brings more risk into the equation, she noted.

"If one underlying goes up, what happens to the other one? It's not easy for an individual investor to run this type of analysis. It's quite complicated," she said.

Finally, if one underlying asset or both are more volatile than the market average, the chances of hitting the barrier do increase, she added.

The historical one-year volatility for the Russell 2000 is 22%, which is higher than the 18% level for the S&P, but "not that much higher," she said. However, the FTSE China fund has a much greater volatility of 26% compared to the benchmark.

"If you incorporate this volatility element with the low correlation between the two underlyings, plus the fact that one underlying is enough to breach the barrier, you can see that many factors contribute to elevate the risk," she said.

The type of barrier is another one.

"Even though the 80% barrier on a one-year looks nice, you can't tell just from that; it's low risk. This is not a final barrier. This barrier can be hit anytime. That's another risk factor," she said.

Return

Future Value measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions - neutral assumption, high and low growth environments, and high and low volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

With a 5.34 return score, the product offers a less attractive risk-return profile than the average, she said. The same product type has a 6.34 average return score in comparison, according to Future Value Consultants' report.

"It's not very good," she said.

"Investors are exposed to a pretty high level of risk. The product needs to provide a higher return in order to compensate them for the amount of risk taken.

"Because there is such high risk, you'd be expecting a higher return.

"The low return score suggests, among other things, that you may get similar returns with less risky products available out there," she said.

With its probability chart, Future Value Consultants estimates how the product is expected to perform under the five key assumptions.

The probability table associated with this product shows a 28.2% probability of losing money, with includes a nearly 17% probability of losing more than 15% of principal per annum. These return outcome probabilities are calculated under the best market assumption, which in this case would be high growth, she said.

"You want the high growth scenario because your best bet from a risk-reward standpoint is to be called on the first observation date," she said.

Low price score

Future Value publishes a price score that measures a note's value to the investor on a scale of zero to 10.

At 3.02, the notes show a much lower price score than the average, she said. Similar callable reverse convertibles recently rated by Future Value Consultants have a 6.87 price score in average.

"It's not very good at all," she said.

"We've conservatively priced the coupon at 8.84% to give the issuer the benefit of the doubt but we're very close to the higher end of the range."

She attributed the poor score to possible volatility levels when the terms were defined.

Another likely explanation may be the complexity of the trade.

"If you get a more unusual combination of assets, a slightly more complex package of options, it may be more expensive for the issuer to put it together. As a result, they may pass on some of the costs in the fees. They may take higher-margin if it's more complicated, which is not to the benefit of the investor. That will lower the price score," she said.

The uniqueness of the trade was another possible reason.

"The more unusual the structure is, the more difficult it is for the investor to compare the product with others. For instance, the correlation risk here is unclear. The pricing may not be as aggressive as it would be with an S&P-based product for instance or a note tied to much more liquid options. When there's more competition and investors can choose from any issuer, price scores tend to be better," she said.

Below average

The price score and return score are averaged to obtain the overall score of the product, which represents Future Value Consultants' opinion on the quality of a deal.

The overall score for this product type is 6.61 in average. The notes only scored 4.18 on that scale.

"It's not very good. But it's not a surprise," she said.

"You have much more risk than what you typically see in this product category. There's a well-below average return score and as a very low price score. There's not a lot going for this product," said said.

The notes are not for everyone, she said.

Investors should be aware of a variety of risks they may not be familiar with not found with other structures, she said.

"This product is for investors looking to make extra coupon. They must have well-informed and specific views on both the Russell and the FTSE China fund. They have to be slightly bullish on both to at least believe that none of the two is going to fall by 20% or more anytime during the 12-month period.

"They're willing to invest for a short period of time and to reinvest this money in three or six months.

"They should be willing to put their capital at risk, in particular, they need to understand exactly correlation risk," she said.

The notes (Cusip: 06741TLC9) are expected to price on Wednesday and settle on Dec. 24.

Barclays is the agent.

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