Advisers focus on protection type, tenor when choosing between deals linked to same underlying

By Emma Trincal

New York, June 11 - As issuers bring to market various deals with different types of protection against downside risk, financial advisers say that barriers and buffers along with duration are the first criteria they look at when picking a deal.

Ultimately, the choice depends on the client's profile, risk tolerance and return expectations, they say.

Two financial advisers compared three upcoming deals all linked to the S&P 500 index. In all three products, the trigger for an enhanced upside is simply the index finishing at maturity above its initial level. Besides that, the type of downside protection, the return enhancement features and the durations varied along with the issuers.

Deals 1, 2, 3

Deal No. 1 is a two-year product with a 20% buffer and a digital payout announced by Citigroup Funding Inc. The issuer plans to price 0% buffered digital securities due July 2, 2014 linked to the S&P 500.

If the final index level is greater than or equal to the initial level, the payout at maturity will be par plus the 12% to 16% fixed return. The downside is protected up to 20% by a buffer. Investors will lose 1% for every 1% that the index declines beyond the buffer.

Deal No. 2, Morgan Stanley's 0% buffered jump securities due 2015 linked to the S&P 500, offer a contingent minimum payment of 28% to 32% if the index finishes positive. If the index gain is greater than the contingent minimum payment, investors will be long the index without any cap.

The downside is protected up to a 25% index decline via a barrier. Once the barrier is breached, investors are exposed to the full loss of the index from its initial level.

Finally, deal No. 3 offers uncapped leveraged upside with a deep buffer on the downside. The price to pay for these features is a geared downside beyond the buffer amount.

Goldman Sachs Group, Inc.'s 0% five-year leveraged buffered index-linked notes linked to the S&P 500 index give investors a payout at maturity of par plus 1.4 times to 1.55 times the index return. The exact rate to be set at pricing.

Investors will receive par if the index declines by up to 50% and will lose 2% for every 1% that the index declines beyond the 50% buffer.

No to downside leverage

Carl Kunhardt, wealth adviser at Quest Capital Management, said he likes the first deal best. His least favorite one is the third one.

His main consideration is distaste for products with downside leverage.

"Different deals, different clients," he said. "I like two of them. I'm not so thrilled about the Goldman Sachs although I can live with it.

"I can see myself using the first one on a moderately conservative client. It's plain vanilla, simple, and you have a neat protection down to 20% from a plain buffer.

"With a more growth-oriented or a younger client, you need to offer more growth while giving protection. That's where the deal No. 2 becomes more attractive. Here you have a high minimum of 30% with some protection. But you have to be moderately aggressive to play that game given the nature of the protection. It's a barrier, so it's more risk."

Kunhardt said that he is more reluctant to consider deal No. 3.

"This one is different. When you sit and talk to the client, you have to explain that past the buffer, they're losing two times on the downside. That two times leverage makes for a difficult conversation. Leverage always gives me pause. Take the financial crisis of 2008. Had it not been for all the money leveraged up in real estate, the 2008 crisis would have been more like 2001," he said.

"Leverage is great on the upside. But on the downside, it's like trying to catch a falling knife."

Kunhardt said that without the negative leverage, the Goldman Sachs deal would be the most attractive deal by far. Despite the appeal of a 50% cushion, the compounding of the losses below that make the product difficult for clients to accept.

"Try to explain to a client that without the downside leverage, they would never get a structure with a 50% buffer, a 1.5 time upside and no cap. It's not going to matter," he said.

"Go and tell them that the 50% buffer gives you twice the protection of a 25% barrier and that you would lose nothing with it if the index dropped by 50% while you would lose 50% with the 25% barrier. It doesn't matter.

"The client is always going to ask 'Why am I getting two times leverage on the downside when I'm only getting 1.5 times the upside?' It boils down to psychology. Clients don't look at the whole picture. They focus on little pieces. They see the downside leverage piece of the deal and they don't like it."

Kunhardt said that those three deals meet different client profiles in terms of risk tolerance and growth expectations.

"On all three, it becomes a question of the client," he said.

"You have to ask yourself, on the risk scale, where does the client fall? How comfortable are they with leverage?

"You have to explain the difference between a barrier and a buffer. It becomes a presentation issue."

Kunhardt said that in terms of market expectation, deal No. 2 would work best for a "volatile and range-bound market."

On the other hand, if the market were to trade outside of a negative 25%-to-positive 25% range, the third deal would become attractive due to the 50% buffer.

"I personally would pick No. 1 any day, even for an aggressive client because even these types of clients need a safe play in their portfolio. I can use it for a wide variety of clients. It's not a difficult conversation, and it has a pretty good buffer," he said.

Protection and tenor

Scott Cramer, president of Cramer & Rauchegger, Inc., said that those deals have the same underlying but different upside and downside characteristics and that it is difficult to rate them in terms of risk because their durations are not the same.

"If I was to choose between those products, I would be looking at the type of downside protection and I would be looking at the term," he said.

When looking at the downside risk protection, Cramer said that the barrier makes the second deal the most risky, even more risky than the third one that has the negative leverage. That's because the deal with the negative leverage has a buffer instead of a barrier. Its protection at 50% is also twice as big as the soft protection of the barrier at 25%.

"Truly, the buffers are going to be a better downside protection than the barrier," he said.

"So I would say the No. 2 has the more risk based on that. It's not necessarily the worse deal. It has an attractive upside, but you need to know you have a barrier on the downside. You get at least 28% to 32%, and it can be more without any limit. It just can't go down by more than 25%. It's a bet that's worth taking, but it's a barrier, not a buffer, so you just need to understand that. There's a little bit more risk because of the barrier."

Cramer examined the products by duration.

"On the first deal, you're in for only two years. You get 12% to 16% with any increase in the index, even if it's only one basis point. It's a good bet. All it needs is for the index to be up and not down by more than 20%," he said.

"The five-year is a little tricky because no one really knows if the market will be down by more than 50% in five years. It's easier to know what the market is going to be next week than five years from now. However, they give you 50% protection. It's a very good buffer. For this type of protection to be triggered, you would need a major event, a terrorist attack for instance."

The five-year product could be a very good fit for some investors though, he said.

"This deal No. 3 has a five-year maturity, some leverage built in, no cap. If you really believe in the stock market over the next five years, this one is a no-brainer. The 50% buffer is very generous," he said.

"You tell a client who is bullish long term that he can get a 50% protection on something he already believes is going to be up plus some leverage on the upside without any cap. That's pretty attractive for that type of investor," he said.

Ultimately, there is not one deal better than another. It depends on the type of client, he noted.

"If you're trying to build a portfolio, you would take different pieces of it," he said.

The Citigroup notes (Cusip: 1730T0XS3) are expected to price June 27 and settle two business days later. Citigroup Global Markets Inc. is the underwriter.

For deal No. 2, Morgan Stanley & Co. LLC is the agent, and Morgan Stanley Smith Barney LLC will handle distribution. The notes (Cusip: 61755S347) will price in June and settle in July.

Goldman Sachs & Co. will be the underwriter for deal No. 3. The Cusip number is 38143UY70.

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