As digitals grow in popularity, advisers consider their options amid market uncertainty

By Emma Trincal

New York, May 24 – Equity-linked digital notes are flourishing as the market is on hold ahead of the next Federal Reserve meeting in June or a potential “Brexit.” Digital products typically do well in a directionless or sideways market. But advisers noted that recent notes of this type come in various flavors based on where the issuer situates the threshold that will trigger the digital payout.

“We’ve seen digitals paying a bonus when the index is above initial price. Others give you something when it’s above a certain barrier, below the initial level. Obviously you’re not going to get the same coupon when you can make money on the downside and on the upside. Whether you would use one versus the other is a function of your view on the market,” said a market participant.

Recently announced deals illustrate the two varieties of digital return notes.

Uncapped

The first one, a worst of, is designed to pay when the reference asset finishes above its initial price. Credit Suisse AG, London branch’s five-year digital plus barrier notes linked to the S&P 500 index and the Russell 2000 index offer the greater of a fixed return of 57% to 61% and the index gain of the worse performing index. The final barrier observed on the worse performing index is 50% of the initial price.

Normally getting an uncapped digital would require extending the maturity probably more than five years, said the market participant. But the worst of feature employed in the structure has enabled the issuer to combine an attractive upside and a low barrier in five years.

The second example showed a digital payout triggered when the index closes at or above a downside threshold.

Coupon, buffer

Barclays Bank plc plans to price 0% 24- to 27-month digital notes linked to the S&P 500 index. If the index finishes at or above 80% of its initial index level, the payout at maturity will be par plus a 7.5% to 8.8% digital payout. Otherwise, investors will lose 1.25% for each 1% decline in the index beyond 20%.

“To me the second one is pretty good. You’re not getting a huge upside: it’s more like 3% to 4% a year. But it’s short-term and you get a substantial protection,” the market participant said.

More importantly, this type of structure may better reflect current market expectations when it comes to the return it may deliver.

“If you can get 3% or 4% a year even if the index is down 20%, that’s pretty good. You’re ahead of the game.

“Besides I don’t know if people are really expecting double-digit returns anymore.

“If you can expand the range that takes you to the coupon and make it work in a down market as well, I think it’s actually more interesting than having a higher cap triggered when the market is up.”

Flexibility

Steve Doucette, financial adviser at Proctor Financial, said he is studying a variety of options available with digital products, a structure he said he is growing to appreciate more.

“There are a lot of possibilities. You can play with the trigger, the cap, the timeframe. I don’t price these things but right now, we’re trying to see where the range is to best fit our view of where the market is heading,” he said.

Doucette said he likes structured notes as a tool to outperform the market in both directions, up or down. In that regard, digital notes, which pay a coupon even when the market is trading down, would be attractive.

“We’re looking at where we are in the market cycle and how we can make money in both markets,” he said.

“If you’re bullish, you’re going without a barrier. You don’t care to be long the market.

“If you see the market moving sideways, collecting the coupon when the market has declined up to a point can be neat.

“It’s a function of your view.’

A digital with a negative threshold may limit the upside while more bullish versions tend to show longer tenors with triggers set at par, according to sources.

“There are many different ways to structure it. These parameters are all going to be adjusted,” said Doucette.

Some advisers are in the market for various profiles of digitals.

Two notes

Steven Foldes, vice-chairman at Evensky & Katz/Foldes Financial Wealth Management, said he was in the process of buying two digital notes, each reflecting a different style.

“The first one has a significant buffer... A hard buffer... The digital coupon is all you get,” he said.

“Our view on this one is that for a relatively short period of time the coupon is enough to satisfy us because we want the downside protection,” he said.

The second note is almost the opposite, but Foldes said both are worth being considered for his firm’s portfolio.

“The other one, which we like a lot is a bit longer, has no downside protection but we’re comfortable with that because we’re bullish on the underlying and also, we get uncapped exposure on the upside, something we really like,” he said.

Foldes is bullish on the underlying asset class.

“It’s tied to emerging markets and we think the worst is behind us,” he said.

The digital, which is triggered above the initial price, is the greater of approximately 11% a year and the index gain, he said.

Foldes said he is about to purchase both notes. But one fits his style more directly.

“We prefer the second one because we like the uncapped participation and the fact that we get at least 10%,” he said.

“You could get more protection. In fact you could almost have it both ways. It depends on how long you want to go out.”

It also depends on investors’ market outlook.

“Your view matters. Are you bullish? Are you worried about the downside? Do you think the market is going nowhere?

Looking at both notes –the defensive one with a lower coupon and the bullish one – Foldes said they can fulfill different types of investors’ needs.

“They’re both valuable,” he said.

© 2015 Prospect News.
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