Svensk's Accelerated Return Notes linked to Russell 2000 offer short-term, mildly bullish play

By Emma Trincal

New York, March 14 - AB Svensk Exportkredit's 14-month 0% Accelerated Return Notes due May 2015 linked to the Russell 2000 index may appeal to investors seeking short-term exposure to the U.S. small-cap market.

The investors using the notes would only expect a moderate increase in the index and seek to invest with a creditworthy issuer, said Tim Mortimer, managing director at Future Value Consultants.

The payout at maturity will be par of $10 plus triple any index gain, up to a maximum return of 11% to 15%. The exact cap will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

Investors will be exposed to any losses.

BofA Merrill Lynch is the agent.

Mildly bullish

"It's a leveraged return note tied to the Russell, the equity benchmark for small-cap U.S. companies. It offers three times leverage on the upside up to an 11% to 15% cap," Mortimer said.

"This structure requires a very modest market growth.

"For a mildly bullish investor, this is perfect. It will only take 3% to 4% a year for the index to get to the cap."

The notes are not suitable for conservative investors as they do not offer any barrier or buffer to reduce or limit the chances of losses, he said. The lack of any downside protection is understandable from a pricing standpoint, he added.

"If you had included some form of downside protection, it would have cost money and would have come out of the upside. Especially with a short-term product like this one, a 14-month deal, you couldn't have introduced any type of downside protection without hurting the cap. The longer the maturity, the easier it is to offer attractive terms in general, including downside protection," he said.

Assuming a 13% cap, investors may find the leverage factor of three very appealing in the event of slow or modest market appreciation.

"If the index grows between zero and just less than 13%, you're going to outperform. If it goes further than 13%, then investing directly in the Russell would be better," he said.

"Many investors expect more modest returns looking forward given the relatively subdued equity market performance we've had so far this year and the strong bull market of last year."

The Russell is up 1.65% so far this year. During the same time last year, it had already gained a little bit more than 9%. Its performance in 2013 was 33.25%.

"With this three-times leverage note, you need a very modest index requirement to outperform, and that's the main appeal of this product, especially if you're concerned that the returns are going to be much lower this year than last year," he said.

Scoring

Future Value Consultants in its research assesses risk, return and price using a variety of proprietary scores in order to compare a product to the entire universe of notes recently rated but also to the average scores for products of the same type. In this case, the product type or structure category is "leveraged return."

The leveraged return category includes any product of any maturity with an upside participation rate of more than 100% whether the product is capped or not and regardless of other terms, such the nature or the existence of a form of protection on the downside.

The riskmap is Future Value Consultants' measure on a scale of zero to 10 of the risk associated with a product with 10 as the highest level of risk possible. The score is an aggregate. It represents the sum of two risk components: market risk and credit risk, which are also measured on the same scale.

Market riskmap

The market riskmap for the notes is 3.28 versus 2.56 for the average of the same product type.

"We have in this category many products that are a lot longer than one year, and longer maturities tend to reduce the market risk," he said.

"If you had a longer product, the probability of having consecutive years of losses without some sort of a recovery would be low.

"Also, you have the fact that a majority of these leveraged notes are tied to the S&P 500 index. The Russell is more volatile than the S&P.

"Finally, the lack of barrier or buffer also leads to this higher market risk.

"It's the combination of those three factors - no protection, short duration and volatility - that contributes to this result."

Credit riskmap

The credit risk associated with the notes works more in favor of the investor than average. According to Future Value Consultants' report, the notes have a 0.41 credit riskmap against an average of 0.64 for the leveraged return category.

"This issuer has a good credit rating. In addition to that, the short-term maturity reduces the credit risk," he said.

When adding the two components, Future Value Consultants finds a 3.69 riskmap. In comparison, the average for this product type is 3.20. The score remains higher than average, but the lower credit riskmap helped contain the overall level of risk, he said.

Return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets, 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.

The notes received a 6.75 return score, which is less than the 7.77 average.

The best market assumption used for the calculation of the score is bull market for this particular product, according to the report.

"The return score is significantly different than the average. It's a one-point difference. The losses affect the score more than the upside. The fact that it has no protection is where it's going to hurt. It's less than the average in part due to the lack of barrier or buffer. However, 6.75 is still not bad," he said.

Price score

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The price score is 5.96, compared with an average of 7.67 for products of the same type, the report showed.

"The fair value of the product is lower than average. It's possibly due to the short maturity. When you have only a one-year, because the implied fees are for the most part fixed, the per-annum effect is going to be a little bit disadvantageous since the fixed cost is spread across a shorter maturity. When you have a longer time horizon, 10 year for instance, the fee is spread over a longer period of time, which helps the price score," he said.

'Respectable'

Finally, the overall score measures Future Value Consultants' general opinion on the quality of a deal. The score is simply the average of the price score and the return score.

The notes have an overall score of 6.36, compared with 7.72 for the average leveraged return product.

"It's a respectable product," he said.

"This issuer has a strong credit rating, but it's not one of the big issuing banks in the U.S.

"If an investor is looking to get a strong credit rating outside of a U.S. bank, this product would be an attractive option. They probably charge a little bit more, and that may also have negatively affected the price score.

"But this may appeal to an investor who is concerned about credit risk and seeks more credit diversification."

Often investors pay attention to the issuer's creditworthiness for longer-dated products. But Mortimer said that credit risk should be a consideration even for short-term notes.

"It may be just a one-year, which carries less credit risk than a five-year note, but you have to put your money somewhere. And when it matures, you might want to roll it into another [Svensk] trade. Anytime you have a risk of default, you want to diversify and invest across different names. You shouldn't take credit risk out of the picture, even if it's for a one-year trade," he said.

In conclusion, he said that the notes were designed for "someone who is mildly bullish for one year and who wants exposure to the U.S. small-cap market with an issuer that offers strong credit."

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