Deutsche Bank's $36.77 million capped knock-out notes linked to S&P 500 offer big buffer

By Emma Trincal

New York, Oct. 12 - Deutsche Bank AG, London Branch's $36.77 million issue of 0% capped knock-out notes due Oct. 24, 2012 linked to the S&P 500 index was seen as very attractive due to its unusually large level of soft downside protection at 44% below the initial price, sources said.

The offering, which JPMorgan sold Friday at an initial index level of 1,155.46, was the second-largest deal priced last week.

'Sweet buffer'

The notes offer an upside potential limited to 10% and an unlimited downside if a knock-out event is triggered, but the knock-out buffer amount of 44% was deemed very conservative by market participants.

"Forty four percent is a sweet buffer," said a market participant.

"I wish I would have seen this one last week. A lot of advisers would have liked it, especially for a short-dated security."

Investors will receive par plus a contingent minimum return of 10% in the absence of a knock-out event. If the knock-out event occurs, the payout at maturity will be par plus the index return, subject to a maximum return of 10%, according to a 424B2 filing with the Securities and Exchange Commission.

A knock-out event occurs if the index falls by more than 44% from the initial level during the life of the notes.

For instance, if a knock-out event does not occur during the term and if the index ends just at 44% below the initial level at maturity, investors will get the digital return of 10% for the year, according to the prospectus.

On the other hand, if the knock-out is triggered and if the index finishes down 20%, investors will lose the benefit of the protection and will lose 20% of their principal.

Finally, whether the event occurs or not, investors' gains will be capped at 10% on the upside. So if the S&P 500 rises 20% for the year, investors will only capture the 10% return, according to the prospectus.

But sources said that the cap is not a concern given the generous contingent minimum return.

"I'm impressed by the soft protection that's available here. Given the market volatility at this time, I would be willing to take a 10% return on a 54-week investment for a 44% downside protection," the market participant said.

"A 10% return for a one year is nice. And a 44% buffer is pretty far out," a sellsider said.

"It's hard to imagine the S&P going down that much, but if it does, you're toast. It's not going to go back up. The cap is going to be irrelevant here. In fact, I don't know why they capped it in this scenario."

Likely scenario

Because the buffer amount is so large, this sellsider said that investors will likely earn the 10% contingent minimum return, making the structure mimic in some ways that of an income product.

"It's kind of like a reverse convertible except that with a reverse convertible, you're guaranteed the coupon. Here, if the index is down by more than 44%, you lose it and that's big trouble. But the chances of this happening in one year are pretty slim, so I'd say the most likely scenario is that you get your coupon and you're done with it," he said.

Observation dates

For the market participant, one less attractive aspect of the structure is the fact that the knock-out can be triggered any day during the one-year period, as an American-style option barrier, instead of being observed once, at maturity, as it is the case with European options.

"I would be willing to take a 10% to 15% trigger if the knock-out was observable at maturity only and not on any day," he said.

"I'm comfortable with a 44% buffer with daily observation. But for simplicity sake and to manage investors' expectations, I'd rather see one observation at maturity and accept a higher soft trigger at 15% or 20%.

"If I'm dealing with institutions, then the daily observations for the knock-out are all right. But the retail investor would probably want to see something more simple."

The Cusip number is 2515A1DG3.

Fees were 1%.

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