Deutsche Bank’s buffered digital notes linked to Russell 2000 are seen as short-term hedge

By Emma Trincal

New York, Feb. 10 – Deutsche Bank AG, London Branch plans to price 0% buffered digital notes linked to the Russell 2000 index, according to a 424B2 filing with the Securities and Exchange Commission.

The notes are expected to mature between 13 and 16 months after issue.

If the index finishes at or above the 85% barrier level, the payout at maturity will be the digital settlement amount of $1,052 to $1,061 for each $1,000 principal amount of notes. Otherwise, investors will lose 1.17647% for each 1% decline beyond 15%.

Both the digital payout and term will be set at pricing, according to the prospectus.

Low return

“The range of returns is very low,” said Tom Balcom, founder of 1650 Wealth Management.

Depending on the final tenor and digital payment amount, the return could vary between 3.90% and 5.65%.

The Russell 2000, which is the small-cap U.S. equity benchmark, is a “long-term holding” that many investors already own in their portfolio, he noted.

“This would be for someone who thinks we’ll have a modest pullback in 2015 and wants to use that as a hedge. It’s a short-term holding on the Russell. But obviously if we have a normal market you’re going to underperform here. It should not be used as a replacement for a long-only exposure unless you’re bearish,” he said.

A reasonably bullish investor would prefer a buffered enhanced return note instead, he said.

“If the market is up 15% and you make 5% with that ... it’s a difficult conversation to have with the client,” he said.

The combination of a short duration and a buffer is a positive feature of the notes, but short duration does not mean less risk.

Short term

“Everything short term is very uncertain; you can’t really control that. Back in October, we had this Ebola scare and the market pulled back,” he said.

The Russell 2000 lost 11% between the beginning of September and mid-October when U.S. equity markets hit their bottom last year.

“If you’re worried about the short-term outcome and want downside protection, this note could make sense. But if you’re wrong, if instead of going up the market goes down, how do you explain it to your client? That’s the problem.”

Special uses

Juin Chin, senior investment analyst at Modera Wealth Management, LLC, said the notes may help some investors.

“When I look at structured notes, I know it’s not for everyone. They tend to have very specific benefits. As part of an estate-planning or tax-planning strategy, for people who want to hedge some of their portfolio or make changes without incurring too much tax liability, this product can be helpful,” he said.

Chin said that the digital return, while not very high and the equivalent of a cap, offers value as a hedge because investors can earn it even if the market declines by as much as 15%.

The downside leverage factor of 1.1764, which is designed to generate potentially a 100% loss of principal, is still preferable to having a barrier or no protection at all.

“Despite the gearing, you have a head start with the 15% buffer. It’s going to protect you better than if you were holding the index directly in a fund,” he said.

Having some protection over a short period of time is one of the most attractive aspects of the deal. The structure could accommodate investors’ needs in some unique cases.

Estate planning

“The short-term period may be used in some specific situations, for instance for someone approaching retirement who is expecting to make a large capital outlay such as the purchase of a residence,” he said.

“It could also be part of your estate plan. If the benefactor expects to pass soon, he or she might place a short-term hedge on the existing equity investments such that at time of passing, the beneficiary may receive a step up in cost basis. This will allow the heir of the assets to properly diversify the assets with minimal tax consequences.”

A step-up in basis is a tax mechanism used upon inheritance that allows the beneficiary's capital gains tax to be minimized.

The notes could also be used as a speculative tool, but Chin said that hedging is the main purpose of the investment.

He offered the example of a hypothetical investor owning a $100,000 portfolio split in two halves, one in bonds and the other in the Russell 2000 index fund.

Hedge

“If you want to buy the notes for $50,000, you could sell the bond portion of your portfolio. When you sell bonds, you don’t deviate too much from your cost basis. You could sell the equity portion of your portfolio, but you would have to realize gains early,” he said.

In his example, the investor sells the bond portion and uses the $50,000 proceeds to buy the notes. The other $50,000 remains invested in the Russell 2000 fund.

“If the index is down 25% at maturity, your hedged portfolio is going to mitigate the risks associated with a full equity exposure. You’ll lose money but not as much,” he said.

“If used as a short-term hedge or a short-term protection, this note can be very helpful.

“It’s not a bullish bet, obviously. See it as some form of insurance.”

Deutsche Bank Securities Inc. is the agent.

The Cusip number is 25152RUQ4.

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