Barclays' contingent payment notes tied to Russell 2000 show discretionary call, 10-year tenor

By Emma Trincal

New York, Oct. 8 - Barclays Bank plc's callable contingent payment notes due Oct. 31, 2023 linked to the Russell 2000 index differ from the typical autocallable product in two ways, sources noted - a longer duration and a call at the discretion of the issuer.

A non-automatic call is "part of the risk with many bonds" and "can be overcome," said Tom Balcom, founder of 1650 Wealth Management.

More problematic in his view is the 10-year tenor.

"I'm not a big fan of longer-date maturities given the current rates environment," he said.

"Anyone who wants to redeem early in this market will incur interest rate risk and potential principal loss. You really have to be aware of that when you seek higher yield."

The product is aimed at yield seekers, he said.

The notes will pay a contingent coupon at an annual rate of 8% to 8.25% if the index closes above the coupon barrier level, 75% of the initial level, on a quarterly valuation date. The exact rate will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

The notes are callable at par plus the contingent coupon on any interest payment date, according to the prospectus.

The payout at maturity will be par unless the index finishes below the 55% barrier level, in which case investors will be fully exposed to losses.

Lengthy and risky

"Investors in this product would have to be pretty much focused on income as opposed to growth," Balcom added. "For those types of investors, losing principal is going to be problematic. Your upside is limited to 8%, but you can lose your entire investment.

"If a person is willing to purchase the product and hold it to maturity, then it makes sense because your return could be more than the yield paid on a Treasury or corporate [bond]. But you would have to understand the risk.

"Also, your coupon is going to be taxed as ordinary income. For clients in a high tax bracket, that's not very attractive.

"I guess it makes sense if you anticipate a flat market. You have to know exactly what you're trying to accomplish and be aware of all the risks. You're getting a coupon above Treasury levels. Anything above Treasuries is risk. There is no free lunch. But the risk is substantial. There is no guarantee of principal. You are not only subject to credit risk but also to a market correction. And your return is not going to be more than the coupon, if you get it."

Michael Iver, chief executive of iVerit Consultancy and a former structurer, said that he likes the deal for moderately bearish investors. The duration of the notes could be less than 10 years, he said, depending on whether a call occurs or not.

"It's a longer-stated maturity deal than usual. The nominal fee of 3.25% is higher than usual, but if the deal lasts longer, the fee is actually lower on an annualized basis," he said.

"You have a 55% final barrier to make up for the longer maturity. That looks nice.

"The notes are callable on the first call date and then on each quarterly date.

"The issuer is going to call you to take back that nice coupon if the market is up.

"But so what? Any day you enjoy an 8% coupon in this market, you're ahead."

On the other hand, if the index is trading below the 75% coupon barrier, the issuer will be less "motivated" to call the notes, he said.

Absolute worst

Iver said that he identified four possible market scenarios with different implications for investors.

"The absolute worst of the worst is if you never get paid your coupon because quarter after quarter the index falls below the 75% coupon barrier," he said.

"You don't get called and you don't collect your coupon. Make it worse: At maturity, the index closes below the 55% barrier and you lose principal. This assumption is very unlikely. Who believes that after 10 years, the index would fall below the 55% threshold? And what are the odds of never getting paid the contingent coupon during the entire period? But for the sake of argument, this is the absolute worst-case scenario."

'Less worst'

The second assumption, which he called "the less worst scenario," would allow investors to earn the 8% annualized coupon for a few years albeit not during the entire period. In a "breakeven" scenario, they may outperform a 10-year Treasury note over a third of the duration.

"In this scenario, the market trades off 20% and you keep your coupon. The issuer doesn't call because they think that you will lose. At maturity, the index doesn't fall below the 55% barrier," he said.

With the 10-year Treasury yield currently at 2.65%, it would take investors in the notes only three-and-a-half years to match the current Treasury rate, he said, without taking into account compounding.

"You can break even the Treasury in a little bit more than three years; you get to enjoy your coupon for a few years. At maturity, you don't lose any principal. That's the less worst scenario," he said.

Steady state

The best-case scenario, he said, would be one in which investors don't see their notes called at any time and lose no principal at maturity.

"This is the steady state scenario," he said.

"You never lose your coupon. The market never trades off by 25%. Let's say it falls by 15% to 20% but it doesn't hit the coupon trigger. They don't call because they think there is a chance for you to lose your coupon. Meanwhile, you are collecting the income, and at maturity, you don't lose any principal.

"This is why I think this note is best suited for a mildly bearish investor because if you're bullish or even mildly bullish, you're not going to enjoy the coupon for very long. You will get called, and getting called early has a steep cost given the fee."

Very early call

A potential early call, as early as three months after issuance, led Iver to project a fourth scenario.

"The market stays the same. It trades up. You get called right away. The outcome for you depends on how soon you will get called. If it's after just three months, there is a risk. The fee can really eat into your return," he said.

Iver concluded that the optimum assumption would be the "steady state" scenario.

"In this particular case, the market would have to trade 15% to 20% lower than the initial strike, sufficiently lower for you not to get called out as the index stays above the trigger. Of course this is not going to keep on happening year after year, but it only takes three-and-a-half years to break even the return you would get by holding a government bond for 10 years," he said.

"I actually like the deal.

"It's for people who are comfortable with the call, who are willing to invest long term and to take on credit risk, people who don't care about the liquidity. They have to be mildly bearish because it's under this scenario that they can keep the coupon as long as possible.

"The only thing I would change is the call protection."

One-year non-call

Investors can get called after just three months, which Iver said is "much too soon."

If the issuer decided to call the notes in January, investors would see the 3.25% fee lower their return.

"This is a risk. I would much rather has a guaranteed call protection for the first year. I don't know how much of the coupon you would have to sacrifice to extend that non-call from three months to a full year, but it might be worth giving up 25 to 50 basis points per annum for the guarantee to be able to get your entire 8% on the first year," he said.

Iver said that the notes reflect the current economy.

"If you're mildly bearish, if you think interest rates are due to go up, if you believe that we are in a slow growth post-recession economy, then it makes sense. I actually like the notes from that standpoint too," he said.

Barclays is the agent.

The notes will price Oct. 28 and settle Oct. 31.

The Cusip number is 06741TQ26.

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