UBS to price relative performance notes linked to S&P 500, NYSE US 5 Year Treasury indexes

By Emma Trincal

New York, Oct. 15 - UBS AG, London Branch's 0% relative performance securities due Oct. 24, 2018 linked to the S&P 500 index and the NYSE US 5 Year Treasury Futures index may offer a disappointing return with more risk and pricing uncertainty than a more traditional structured note tied to only one asset class, sources said.

The return of the notes is based on a relative performance between two asset classes.

Investors are betting that the S&P 500 will outperform the return of U.S. Treasuries over the term, according to a 424B3 filing with the Securities and Exchange Commission.

The S&P 500 is the "long index," and the Treasury index is the "short index," according to the prospectus.

The relative return is defined as the long index return minus the short index return.

If the long index return is greater than or equal to the short index return, the payout at maturity will be par of $10 plus 127% to 134% of the relative return. The exact participation rate will be set at pricing.

If the long index return is less than the short index return, the payout will be par plus the relative return, which will be negative.

If the S&P 500 gained 25% at the end of the term and the Treasury index lost 10%, the relative return would be 35%, according to one of the hypothetical examples in the prospectus. With a leverage factor of 1.305, investors would receive a positive return of 45.67%.

Tenor

Steven Foldes, president and chief executive of Foldes Financial Management LLC, said that the tenor, the complexity of the payout and the pricing uncertainty are real concerns.

"The five-year [tenor] is problematic for us," he said.

"We typically buy notes shorter than 24 months. Given the reduced volatility, we've extended our limit to 36 months, but we would not go beyond that."

Pricing

Another concern, which Foldes said is not necessarily a "negative" but merely "a question for the issuer," is about secondary market valuation.

"How do you get to sell prior to maturity? One of the things that are really important for us is the daily pricing with daily liquidity. We have from time to time clients who want to sell early, so it matters to us," he said.

"How is this note going to be priced compared to a traditional buffered note with downside protection and upside leverage with a cap? That's my next question."

Foldes explained that with the typical leveraged buffered and capped note he usually buys, pricing becomes more transparent as one gets closer to the end of the product's term.

"At first, pricing is somewhat reflective of the asset class, but once you get close to maturity, you depart from the asset class pricing and the leverage component kicks in, which can boost the value of the note if you know that you are going to benefit from leverage and hit the cap embedded in the notes" he said.

"The transparency of the pricing prior to maturity is more obvious with the traditional leveraged buffered note because uncertainty decreases as you get close to maturity."

In contrast, pricing with these notes is likely to be "fairly difficult" because the return is not linked to one asset class but to the returns of one relative to the other, he noted.

Relative value

"Your return is a function of the performance of stocks versus Treasuries. It's much more complex," he said.

"Even if it appears that the Treasuries could be negative and stocks positive, it remains to be seen what the differential would be. Obviously, the leverage is not a bad thing here. But these notes have a lot of moving parts that would give me a lot of concerns.

"The concept of relative performance tends to complicate the issue. It will be really difficult to explain to a client that you're not just dealing with the S&P but also with Treasuries and the difference between the two."

Risk-adjusted return

For Dean Zayed, chief executive officer of Brookstone Capital Management, the five-year bet on the relative performance is risky based on the projected returns for stocks and bonds.

"I don't like this note," Zayed said.

"We always gravitate towards easier structures which clients can understand. I don't see this fitting into that category. This is more the complicated type.

"Most analysts project that future returns for both stocks and bonds will be anemic.

"If stocks and bonds won't do so well over the next five years, the differential between the two may not yield very impressive results.

"It's a point-to-point in a five-year period. There is no coupon, nothing to keep you in there until the five years is out. There is no principal protection.

"I think stocks will outperform bonds, but this doesn't necessarily make the notes attractive.

"The S&P will likely outperform Treasuries over the five-year period. But the question is by how much. It may not be enough to put your entire principal at risk for five years with no coupon."

The notes (Cusip: 90271M757) are expected to price Oct. 18 and settle Oct. 23.

UBS Financial Services Inc. and UBS Investment Bank are the underwriters.

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