Issuers have to be 'creative' to price shorter-term notes with attractive downside protection

By Emma Trincal

New York, Jan. 13 - Issuers who want to offer attractive downside protection while keeping maturities under two years need to be "creative," buysiders said.

Given today's pricing conditions, the trend has been so far to extend maturities. But for clients who insist on getting shorter tenors, several options are available, according to recently announced deals, such as very low caps, high-volatility underliers or downside leverage beyond a buffer, they noted.

"We've seen all of these trends," said Scott Cramer, president of Cramer & Rauchegger, Inc.

"The problem issuers have in this low rates environment is that in order to get downside protection, they've been forced to extend maturities. The guaranteed full downside protections have gone away. Issuers have had to devise more innovative ways to get some sort of downside protection."

Issuers recently announced three products featuring downside protection that individually represent alternatives to the longer-dated leveraged buffered note, they said.

Low cap

HSBC USA Inc.'s 0% SelectInvest debt securities due Jan. 28, 2015 linked to a basket of indexes and exchange-traded funds exemplify the trend of caps that are flatter to a point where the note hardly competes with a high-yield bond, said Carl Kunhardt, wealth adviser at Quest Capital Management.

The basket consists of the S&P 500 index with a 40% weight, the Russell 2000 index with a 20% weight, the iShares MSCI MXEA exchange-traded fund with a 30% weight and the iShares MSCI Emerging Markets exchange-traded fund with a 10% weight, according to an FWP filing with the Securities and Exchange Commission.

If the basket return is greater than zero, the payout at maturity will be par plus the basket return, subject to a maximum return that is expected to be at least 4.8% and will be set at pricing. If the basket declines by 10% or less, the payout will be par. If the basket declines by more than 10%, investors will lose 1% for every 1% that the basket return is below negative 10%.

"You get a 10% buffer, but 60% of the basket is in high-volatility positions," Kunhardt said, pointing to the Russell 2000, the emerging markets ETF and the iShares MSCI MXEA ETF. The latter tracks the MSCI EAFE index, which tracks developed countries, in particular Europe.

"Getting a 60% exposure in high-volatility asset classes just to get a bad return of 4.8%, I'd rather be in high-yield bonds. For the amount of risk you're taking, you're not getting compensated," he said.

Volatile underlying

The second structure is a one-year product allowing investors to get 1.5 times upside leverage exposure up to a 20% cap while enjoying some downside protection through an 80% European barrier.

The trade-off, however, is the high volatility of the underlying basket, Kunhardt noted.

Barclays Bank plc's 0% SuperTrack notes due Feb. 19, 2015 are linked to an equally weighted basket of refinery stocks: Marathon Petroleum Corp., Tesoro Corp. and Valero Energy Corp.

"I can understand why they would be doing that. Volatility is low, and buffers are hard to price," Kunhardt said.

"But I wouldn't do this deal either. You get three companies which not only are all in energy but also are all refinery stocks. You have absolutely no diversification. Within energy, they could have picked pipelines, fuel extraction, nuclear reactors. But you have this concentration in this refinery business. Finally, all three stocks are very economy-sensitive. They're all cyclical."

Downside leverage

Another solution, which is exemplified by Deutsche Bank AG, London Branch's 0% capped leveraged buffered notes linked to the iShares MSCI Emerging Markets ETF, is to slightly extend the term while keeping it short and to introduce some leverage on the downside.

The notes are expected to mature 16 to 19 months after pricing.

If the fund return is positive, the payout at maturity will be par plus 1.4 times the return, subject to a 17.85% to 20.65% cap. Investors will receive par if the fund falls by up to 12.5% and will lose 1.14286% for every 1% decline beyond the 12.5% buffer.

"They include leverage on the downside," Kunhardt said.

"I know that you're still better off with that type of buffer than you would be with a barrier all things being equal. If the fund was down 35% and if I was long the fund, I would be down 35%. With that, I would only be down a little bit less than 26%. There is value there. I understand that. But it's a personal bias. I don't like leverage on the downside, and my clients won't like it either because they see I'm not comfortable with it."

Necessary trade-off

"These three structures are not entirely plain vanilla. They give you downside protection on a relatively short-dated maturity, but I'm not crazy about how they achieve that - by including a very volatile underlying, cutting the cap to a very low level or throwing in some leverage on the downside," he said.

For Cramer, the market is such that investors have very little choice if they want buffers or low barriers. They either have to settle for those types of structures or be willing to invest over a longer period of time.

"Many times, in order to get a buffer, you have to accept a low cap, such as in the first example," Cramer said.

"Those who want a solid downside protection have to be willing to give up some of the upside. If they're not, they usually have to go longer.

"If they still want to get a solid downside protection and keep the maturity short, the options are limited. They have to accept a more volatile underlying, as it was the case with the notes tied to the refinery stocks, or they have to accept the downside leverage. For the issuer, the leveraged option on the downside is less expensive than is the straight option.

"That's all they are doing: trying to price these short-term deals with decent downside protection.

"Those things are never good or bad. It depends on what the investors want to do and how the product fits into their portfolio and if it matches their overall objective. Investors are going to have to decide on the type of trade-off they're willing to live with if they want some downside protection."

Going longer

Kunhardt agreed that those three structures are the result of pricing challenges.

"Issuers have to be creative in this low-volatility environment in order to respond to the demand for shorter, well-protected notes. But to me, all these three products showed risk return profiles that were unattractive," he said.

"I'd rather go longer than two or three years. Most of our recent investments jump over the three-year threshold; most are five years. Sometimes we go as far as seven years.

"If that's the only way to get a decent, well-protected plain vanilla note, I'd rather go for the extended maturity, which is what issuers have been doing so far for the most part.

"The only reason those three products stand any chance to appeal to some investors is because the market is not conducive for investment-grade intermediate bond funds to make money.

"Either you go short, very short on one-and-a-half year to three-year in order to maintain the credit quality or you go longer and you lose on credit quality.

"The reason these notes have any chance to sell in this market is because you need something not correlated to equity and that the traditional place to look, bonds, just isn't there."

HSBC Securities (USA) Inc. is the agent for the HSBC notes, which will price Jan. 27 and settle Jan. 30. The Cusip number is 40432XQ79.

Barclays is the agent for the Barclays notes, which were expected to price Monday and settle Thursday. The Cusip number is 06741T4P9.

Deutsche Bank Securities Inc. is the agent for the Deutsche Bank notes. The Cusip number is 25152RGV9.

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