Barclays’ step-up callables linked to Russell, Euro Stoxx seen as bond-substitute strategy

By Emma Trincal

New York, March 12 – Barclays Bank plc’s step-up callable notes due March 31, 2025 linked to the lesser performing of the Russell 2000 index and the Euro Stoxx 50 index are a good way to get above-average yield for investors willing to invest for the long term knowing that their investment may be called, said Steve Doucette, financial adviser at Proctor Financial.

The equity derivative provides for a reduced exposure to interest-rate risk, he noted.

Part of the appeal of the product is the guaranteed 9% interest rate per year for the first year, he said. The depth of the final barrier is also advantageous.

After the first year, the notes will pay a contingent coupon each quarter if each index closes at or above its coupon barrier level, 75% of its initial level, on the observation date for that quarter, according to a 424B2 filing with the Securities and Exchange Commission.

The contingent coupon rate will be 9% per year for the first 12 contingent coupon observation dates, 11% per year for contingent coupon observation dates 13 through 28 and 13% per year for contingent coupon observation dates 29 through 36.

Beginning March 31, 2016, the notes will be callable at par on any interest payment date.

The payout at maturity will be par unless the final level of the lesser performing index is less than its barrier level, 50% of its initial level, in which case investors will be fully exposed to the decline of the lesser performing index.

Eye catching

“I’m always amazed at those contingent coupon deals. Why do they always look too good to be true? This one certainly looks very interesting,” Doucette said.

“As an investor you get a guaranteed 9% coupon on the first year. They’re paying you this premium up front. Right there, it’s more income than what you would ever get on a regular CD.”

Most traditional certificates of deposit do not exceed five years. A top rate for a five-year jumbo CD is 2.27%, according to bankrate.com, an online aggregator of CD rates across the country.

Principal at risk

Investors naturally run the risk of a market downturn, which means either no coupon payments for a certain period of time or possibly a loss of principal if the notes mature, he said.

But given the low 50% barrier at maturity, Doucette reasoned that a potential correction in either of the two underlying indexes would be more likely to impact the frequency of income payments than to put principal at risk.

Win-win

“Theoretically, the market could be down for the next three years. So what? You’ve collected 3% per year up front,” he said.

“You hold it and when the market recovers you start to collect the coupon. Of course the catch is that if the market is up, they’re going to call you. So it’s a timing thing.

“But assuming you’re not called and run the risk of losing principal at maturity, I can’t imagine any of those two indexes being down 50% in 10 years. Even 10 years after the 2001 bear market, and same thing after the 2008 financial crisis, you didn’t find yourself down 50%. Breaching the barrier in 10 years is possible, but it’s unlikely.

“So chances are you either get called, and that would happen shortly after the first year if the market is up, or, worst-case scenario, you collect a nice coupon.

“If we have a bear market, you don’t get called for two years, but you start to clip the coupon as soon as the market rebounds.”

Time

Two factors of unpredictability are the length and timing of the next bear market if there is one and the issuer’s discretion to call the notes if the market continues to rally, he explained.

“It’s a bit hard to predict. Are we continuing the secular bull market, or are we about to go through the next bear market? But given the short length of the average bear market, you’re in a good position to earn some nice income,” he said.

“As for the call, you can assume they will call you if the market is up. But even still ... at least you had a chance to pocket some very good yield down the road.”

Bond replacement

Doucette said he invests in contingent coupon notes and uses those products as bond replacements.

“It’s not an equity-replacement strategy; it’s a bond substitute. We buy them as a way to hedge interest-rate risk,” he said.

“It has some disadvantages too. You’re getting a coupon, so you’re taxed as ordinary income.”

Another issue, at least for this product, is the term.

“It’s still a 10-year. If the market is ugly, you can’t liquidate this note because it tracks the index. They’ll give you very little for it. I don’t like long durations.”

If the notes were to be called, the reinvestment risk would be limited, he said.

“It’s not as big a deal as when interest rates were declining,” he said.

“And also, it’s not your typical fixed-income instrument. It’s a combination of an equity derivative and an income component. You’ll be able to replace the notes with better terms.

“As a fixed-income substitute, looking at a possible 9%, that’s a heck of an income substitute. How many bonds in emerging markets or high yield are delivering that kind of return?”

Wild card

For Matt Medeiros, president and chief executive of the Institute for Wealth Management, the issuer’s right to redeem the notes at any time after one year is a concern. In addition, the tenor is longer than desired.

“I’m not in favor of 10-year notes. It’s very long in nature. The market the way it is right now ... I’m more in favor of short-dated products. I wouldn’t be buying the notes,” he said.

“Obviously, anytime an issuer is going to call the notes is when economically it’s in their best interest to do so, which makes it challenging from an investor’s perspective to set expectations.

“You’re buying a note. You’re making a 10-year commitment. That’s the first thing. But then, after a year, if it gets called any time at the issuer’s discretion, it’s challenging to model and predict your portfolio return.

“If the note was tied to a less volatile index or pair of indexes, it would be much more predictable ... something that fluctuates a lot less than European stocks and small caps ... large caps for instance.

“On top of that, it takes two indexes to be at a certain level to get paid and only one to lose money at the end. The worst-of structure adds to the uncertainty without a doubt.”

Finally, Medeiros pointed to the risk associated with uncorrelated assets in a worst-of payout.

“The Euro Stoxx and the Russell 2000 may have currently a high correlation, but that doesn’t necessarily hold,” he said.

Barclays is the agent.

The notes will price March 26 and settle March 31.

The Cusip number is 06741USB1.

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