Barclays' annual reset coupon notes linked to Russell 2000 make for slightly risky income bet

By Emma Trincal

New York, March 6 - Barclays Bank plc's annual reset coupon buffered notes due March 29, 2019 linked to the Russell 2000 index offer an above-average yield for investors willing to receive a coupon based on market conditions.

The trade-off, however, may be less appealing, sources said, citing the uncertainty of the coupon amount, a capped upside in the form of a digital coupon, a relatively long duration and up to 80% of principal at risk at maturity.

Interest is payable annually and will equal the maximum digital percentage if the index's return for that year is positive or zero. Otherwise, the coupon will equal the minimum digital percentage. The index's return will be measured from its level a year earlier, according to a 424B2 filing with the Securities and Exchange Commission.

The maximum digital percentage is expected to be 5.1% to 6%. The minimum digital percentage is expected to be 1.5% to 2%. Both will be set at pricing.

The payout at maturity will be par unless the final index level is less than 80% of the initial index level, in which case investors will lose 1% for every 1% that the index declines beyond 20%.

Poor risk-return trade-off

Steve Doucette, financial adviser at Proctor Financial, said that he does not like the risk-return profile of the structure even though the size of the buffer reduces the odds of losing money.

"You get 1.5% to 6% maximum annual return over five years, so the most you can do is 30% on the upside. And you can lose up to 80% of principal. Overall, I'm not fan of the risk-return characteristics of that note," he said.

One positive feature, however, is the 20% buffer, he said.

Less interest rate risk

"I can see that some people may use it as a way of collecting coupons with slightly less risk given the 20% buffer," he said.

"Five years from now, who knows if the Russell 2000 will be up or down. But the buffer over that time period gives you less risk of losing money than with many other products.

"The question is, do I need to lock myself for five years? It might make sense if interest rates go up because this investment tied to an equity index is not interest-rate sensitive. But I can't get excited with not getting more than my coupon while putting theoretically most of my money at risk."

Doucette conceded that the digital payout offers some value. In all cases, investors are guaranteed the minimum coupon. They could alternatively get the maximum return under certain conditions pertaining to the index performance.

"But I'd rather look for other coupon-generating ideas, and there are many place to look into. You have the whole bond market world, dividend stocks, real estate. If you look for income, there are lots of ways to get it. Is this note the best place to get income? I think you can do better somewhere else without this cap," he said.

Uncertainty

For Matt Medeiros, president and chief executive of the Institute for Wealth Management, the greatest drawback in the structure is uncertainty of return, which defeats the purpose of investing for income, he said.

Even if the structure guarantees the minimum digital coupon of at least 1.5% a year, the more attractive coupon depends on the underlying index remaining flat or higher from the previous year, he noted.

"It's an income instrument, so my first reaction is, why would you peg it to the Russell?" he said.

"The Russell can fluctuate wildly. It also has a strong potential for appreciation, especially over five years, and you're getting something capped at 6% a year in the best-case scenario? You're taking an index that has high standard deviation and you're capping it at 6%?"

Even if one is satisfied with the 6% maximum annual return, the index needs to continuously grow from the previous year, not from the initial price, he noted.

"It makes the conditions required to get the highest yield more difficult to meet," he said.

"If I was interested in income, I'd probably want a different asset class because as an income investor, I would want consistent and predictable income. The range between 1.5% and 6%, and it's going to be either one or the other, is a pretty wide range. If my goal is to generate income, I'm going to be looking for something that's more predictable."

Versus corporate bonds

With the 10-year Treasury yield at 2.7%, investors may look for corporate bonds to get additional yield, he suggested.

"If I was hunting for yield in the corporate space, I don't know if I would be getting 6%, but the risk-return trade-off would probably be better. At least I would know what my coupon is and I would know that I'm getting my principal back assuming no negative credit event of course," he said.

Medeiros also pointed to the relative lack of interest rate risk exposure as one advantage offered by the product.

"With corporate bonds, a rise in interest rates would push down the price of my portfolio. In that regard, the notes offer a potential advantage over traditional fixed-income instruments because they wouldn't be interest rate sensitive," he said.

No laddering

But the unpredictability of future income remains his main concern.

"From my perspective, as an investment manager, I think that the type of investor looking for a coupon is going to want something a little bit more dependable than this 'either/or' type of digital payout," he said.

"If I want to build a laddered portfolio, this type of product wouldn't be a good fit. Not knowing what my income is going to be would make it difficult to structure an income-type of portfolio.

"Add to that the complexity of predicting what type of income I'm getting. I could get five years with the highest coupon or only two or three, or none."

Hypothetical returns

The prospectus offered some hypothetical examples of total return scenarios based on the aggregate annual coupons. The examples use a 5.1% maximum digital percentage and a 1.5% minimum digital percentage.

The best scenario would be the one in which the index would be flat or higher for all five observation periods, which would result in an annual coupon payment of 5.1% a year five times, or 25.5% over the term of the notes, according to the prospectus.

In the worst case, the Russell 2000 index would be negative for all five observation periods, resulting in an annual coupon payment of 1.5% for each of the five years, which would be 7.5% for the term of the notes.

In between those two extremes, the number of years in which the conditions for the higher coupon payment would be triggered could vary.

In another example, the prospectus assumed that the annual return was positive or flat for three observation periods and negative for two. The result would be an aggregate return of 15.3% for the three "positive" years (5.1% times three years) and 3% for the "negative" years, which would give investors a total return of 18.3% over the five-year term.

Too complex

"Obviously, you've got a lot of complexity," Medeiros said.

"Such complexity would make it challenging to plan for future income stream or to put together an efficient risk-mitigation strategy.

"If I need 5% a year, it's hard to track something like this. I could be out 60% of the return or more.

"What investors are looking for when they build a laddered portfolio is to be able to predict the exact cash flow stream they will receive each year.

"This note doesn't achieve that because you don't know in advance what your coupon is going to be. You don't even know if you're going to get all of your money back at maturity.

"I have to say, this note is an interesting one. I get the concept. But I would have to hear a pretty strong pitch to consider putting it in my portfolio."

Barclays is the agent.

The notes will price March 27 and settle March 31.

The Cusip number is 06741T6Z5.

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