UBS’ contingent return optimization notes tied to Russell 2000 may provide alpha

By Emma Trincal

New York, Dec. 11 – UBS AG, London Branch’s 0% contingent return optimization securities due Dec. 29, 2017 linked to the Russell 2000 index give investors a chance to profit in both an up and down market via a structure sources said would likely be shown more often.

If the final index level is greater than or equal to the trigger level, 75% of the initial index level, the payout at maturity will be par of $10 plus the greater of the 8% contingent return and the index return, subject to a maximum return of 30% to 36% that will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the final index level is less than the trigger level, investors will be fully exposed to the index decline.

Potential alpha

“It’s a neat note,” said Steve Doucette, financial adviser at Proctor Financial.

“You do get that 8% even with a negative return, at least to a point. If three years out, the market is down but not to the point of hitting that trigger, if it’s down 25%, you get 8%. That’s a 33% outperformance over the benchmark. Not bad for an equity substitute. On the upside, you’re long the index up to the 30% cap. At least you have the protection level through the corridor.”

The upside offered was also satisfying in his view.

“You could get capped out but 10% is a pretty good return to take home especially when you have the protection component.

“I sort of like it. You don’t know where the market is going to be over the next three years, and you’re trying to capture the upside while taking advantage of some of the downside too.”

Different

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said that he liked the structure.

“It’s very interesting. I haven’t seen it before,” he said.

“Three years for small caps is relatively short-term. I like the idea that even if the index is negative but not to exceed 25% you get a positive return of 8%. It’s pretty compelling.

“On the upside as far as the cap, I don’t think we’ll see a runaway bull with small cap returns of 30% per annum.

“These are notes for someone who is bullish and who expects a market rotation from large cap to small cap.”

Other structures offer positive returns when the index declines. Absolute return products, which give investors the absolute value of each point of decline up to a barrier level are similar in concept. But the payout is different, he said.

“With this one, if the market is down 24% you get 8%. The absolute return one would give you a 24% gain. It looks more generous but the terms would be different obviously. You may get a narrower band above the trigger on the downside. The cap on the upside would probably be lower,” he said.

Some structures combining a digital payment on the upside with some participation above the digital level also exist. But they usually don’t offer gains for negative index performance. An example are the market-linked step ups which give investors a fixed return or step payment when the index finishes between its initial price and the step level along with full participation above the step. Those structures offer the advantage of being uncapped on the upside. However they usually offer no downside protection let alone any sort of positive return from a declining index.

“This deal is a little different. It’s sort of a new structure worth taking a look at,” said Doucette.

More to come

The agent for this deal, UBS Investment Bank, is also readying three other offerings based on the same type of structure but linked to the S&P 500 index. All three also have a three-year tenor. UBS will issue one with the same 30% to 33% cap range; Royal Bank of Canada, with a 30% to 36% cap, will bring to market the second one; finally Morgan Stanley will price the third one, showing the same 30% to 36% cap range.

The main difference with the Russell notes will be the trigger level, set to be at 80% rather than 75% of the initial price.

“Whether to use the notes on the Russell or on the S&P would be an asset allocation decision. I would have to see what works best in my portfolio first,” said Doucette.

“If I had to choose between the two indexes, if the structure and the terms were exactly the same, I would choose the Russell over the S&P,” Medeiros said.

“The earlier business cycle did not lend itself to favor small caps; I believe it does now.”

The notes tied to the Russell 2000 (Cusip: 90274F239) are expected to price Dec. 26 and settle Dec. 31.

UBS Financial Services Inc. and UBS Investment Bank will be the agents.

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