Deutsche Bank's 5% notes linked to EAFE ETF, Russell 2000 are too risky for a capped upside

By Emma Trincal

New York, May 22 - Deutsche Bank AG, London Branch' $1 million of 5% securities due May 20, 2015 linked to the Russell 2000 index and the iShares MSCI EAFE exchange-traded fund offer a higher coupon in exchange for exposure to the downside risk of the worst of the two underliers. But sources said the trade-off is not attractive enough from an equity standpoint and too risky for an income investor.

Interest is payable monthly, according to a 424B2 filing with the Securities and Exchange Commission.

If the final level of the lesser performer is at least 85% of its initial level, the payout at maturity will be par. If the final level is less than 85% of the initial level, investors will lose 1.1765% for every 1% decline in the worst-performing underlier.

Good protection

Steve Doucette, financial adviser at Proctor Financial, said that the downside protection is the most appealing aspect of the deal.

"It's a mix of Europe and U.S. which I'm seeing for the first time," he said.

"Those two are pretty well correlated with a coefficient of 85%. According to Morningstar, anything above 75% is high correlation. So that's a plus for a worst-of because the correlation lowers your risk.

"The downside protection is the attractive part of the deal.

"They give you a 15% buffer with leverage beyond that. So a 20% decline of the worst performer would give you a 5.9% loss only. It's a great way to outperform the market, at least on the downside.

"Not only that: you do get the 5% coupon. If you divide it by the multiple, you get an additional 4.25%. So really your breakeven on the downside is 19.25%. Starting at 19.25%, that's when you eat up that coupon.

"Given that we're dealing with two highly correlated broad benchmarks and that you have that 20% level of protection, you should do well. A bear market is 20%. You should still be ahead of the market."

Bearish

However, there is a contrast between the expected maximum return limited to the coupon and the depth of the downside protection, making the profile of a buyer of the notes slightly atypical.

"The outlook is not optimistic. The view is, the market will never go up more than 5% but could go down quite a bit and I want protection. You'll get a 19.25% protection. I don't know how else you can look at it [but] as being bearish," he said.

But making a directional bet is not the purpose of the structure.

"The reason for doing this is yield," he said.

"You can't find 5% on a one-year investment without high risk. If interest rates rise, you are losing money. In some respect, it might be a decent income replacement, a decent hedge against rising interest rates. You collect 5%, and you're protected unless the market gets really ugly.

"The problem is if you do a bond substitute, you're risking the downside.

"It's a worst-of, and while the underlying indexes are highly correlated, still, you do have risk."

Unclear allocation

The weakness of the structure is the result of the risk-reward profile of the notes.

"The risk-reward component is a little disappointing. You have unlimited downside with a limited coupon. I don't really like this type of trade-off, I don't really like the odds, but on the other end, they offer an attractive buffer," he said.

The problem is finding the right allocation for the product because it does not satisfy the low-risk requirements of a fixed-income investment nor the expected returns of equity.

"From an equity perspective, the risk-return component is a problem," he said.

"I don't think I would find a place in my asset allocation from an equity perspective. And from a fixed-income perspective, can you look at 5% with less risk? Sure you can. I can find an autocallable with 40% downside protection and still collect an 8% coupon. So I don't think I would want to get that much risk for 5% when I can find more upside and more protection elsewhere."

Too much risk

Matt Medeiros, president and chief executive of the Institute for Wealth Management, is not even convinced that the downside protection is attractive.

"I wouldn't be interested in something like this," he said.

"I can see that getting a 5% coupon on a one-year is attractive. But I think you can find something similar from a coupon perspective without such downside risk.

"Taking on the equity risk, and not just of one benchmark but on the worst of the two, just to get a 5% coupon, I'm not sure I would consider this.

"Obviously, the buffer is nice. But I wouldn't need so much buffer if I could find a similar coupon without the equity risk. I am not a huge yield shopper. But if I did some research and was interested in yield, I'm sure I wouldn't have to search too far to find something with similar yield and less risk."

The notes (Cusip: 25152RJU8) priced May 16.

This brings the deal size to $2 million. The issuer priced the initial $1 million of the notes on April 15.

Deutsche Bank Securities Inc. is the agent.

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