Deutsche Bank's two leveraged capped S&P 500-based deals generate opposite views in advisers

By Emma Trincal

New York, March 3 - Deutsche Bank AG, London Branch is readying two short-term leveraged capped notes offerings linked to the S&P 500 index with one focusing more on leverage and the other on downside protection. An adviser said that both products are appealing in different ways, but another finds both structures disappointing.

In the first deal, Deutsche Bank's 0% Accelerated Return Notes due May 2015, the issuer offers no downside protection but provide a leverage factor of three on the upside up to a 10% to 14% cap, according to a FWP filing with the Securities and Exchange Commission. The 14-month deal is expected to price in March.

The second product, Deutsche Bank's Capped Leveraged Index Return Notes due March 2016, offers a 10% buffer on the downside and is longer in duration. The cap range is the same. The leverage factor is two. This deal will also price this month.

BofA Merrill Lynch is the agent for both offerings.

For Carl Kunhardt, wealth adviser at Quest Capital Management, both structures offer their own advantages with one product seen as more aggressive than the other.

"I like them both," he said.

Three-times upside leverage

The first deal is particularly attractive for its three-times leverage factor on the upside, compared with a one-to-one downside exposure, Kunhardt said.

"The 14-month would fit into my more aggressive strategies. I can use that as a return enhancer. You're not picking up any more risk on the downside, so to me the leverage on the upside justifies the cost," he said.

Both deals carry a 2% fee.

"I wouldn't want to go over 2.5% or even 3%. But 2% is fine," he said.

"In a way, the three-times leverage is moot because you're going to hit that cap. It's only a 14-month [note]. But having three-times leverage on the upside and no leverage whatsoever on the downside is very attractive if you compare this payout to being long only on a leveraged basis because you would have the downside exposure as well if you were long the index.

"There's a cap, of course, but I'm comfortable with the cap because of this payout profile, the three-times up and one-to-one down. That's the price you pay for having a better risk reward than if you held a long-only position."

Attractive buffer

Kunhardt said about the second deal that it would be a good fit for his "moderate, balanced growth" portfolio due to the buffer.

"You lose one times leverage for the buffer. It's one year longer, and you get the same cap, so yes, the cap is lower [on a per-year basis], but that's the price you pay for the buffer," he said.

"I'm comfortable with a 5% to 7% a year return. It's not far from meeting my expectations for the S&P 500, and I get that downside protection, which is very valuable.

"The S&P is the U.S. large-cap core asset class. Over the long term, I expect about 8.5% per year. With this note, I'm only giving up 1.5% to 3.5%, but I'm getting 10% on the downside.

"With everything that's going on in the world right now, I think it's worth it."

Both products share some common attractive features, he said.

"I like the fact that both deals are plain vanilla. They have a common set of core structure. They're both easy to explain. They're both linked to the S&P 500, which is a pretty conservative asset class," he said.

One note could easily complement the other, he said.

"One is more aggressive and gives you more leverage because there is no downside protection. But you're not worse off than being long-only," he said.

"The other has a lower cap and less leverage, but you're getting a 10% buffer on the downside, and that's how you're paying for it. You're not worse off; you're better off than buying the index directly.

"I think both deals are pretty good."

Not good enough

Michael Kalscheur, financial adviser at Castle Wealth Advisors, sees a limited number of benefits in the deals. Overall, neither of them meets his criteria.

"They're both straightforward, and normally I like straightforward deals," he said.

"Deutsche Bank is the issuer. They're not my top two names in terms of credit. It's not Royal Bank of Canada or Wells Fargo. But they're in the middle of the pack, so I wouldn't knock it out of contention. I'm pretty comfortable with them.

"And yet, I don't like any of those two deals. Neither the cap or the buffer is nearly good enough."

Tenor and buffer

While some advisers like short-term products, Kalscheur said that he prefers longer maturities.

"I consider anything two years or less pretty short term, and that's not why we buy structured notes," he said.

"We try to talk to clients about investing for the long haul. I have no problem with three, five, even seven years."

Kalscheur added that his preference for longer-dated notes is also a matter of risk mitigation.

"The shorter the term, the more buffer you need," he said.

"The first deal has no protection whatsoever, which in our opinion defeats the purpose of having a structured note.

"And while the second deal has a buffer, it's 10%, and a 10% buffer on a two-year note is too little for us. On a five-year [note], I can do 10%, but not on two years."

Kalscheur explained why he sees shorter products as riskier.

"The longer the term, the more time you have to recover if the market drops," he said.

"Also, the market has more time to build up before the drop.

"So even though the second deal offers a buffer, it's not enough to make me feel comfortable."

One way to win

Kalscheur mentioned other "problems" associated with both deals, including the cap and the fee.

"The first deal gives you a lot of leverage, but you're capped out at a pretty low level," he said, adding that the cap could be as low as 8.6% a year without taking into account compounding. With the 300% participation rate, the index would only need to appreciate by 2% to 3% a year for the cap to be hit, he said.

"That's not very impressive. You could have a good week and the market would be up that much. Having a cap that low is not that exciting," he said.

"And then you have this 10% to 14% range. That's a pretty big spread."

For Kalscheur, the cap is "the main problem."

"In order to like the notes, you have to be pretty low key about the market. You have to bet that it's going to be up 3% to 4% a year. Nobody thought last year that the S&P 500 would be up 30%, but it was. Everybody who was defensive was left in the dust."

Kalscheur turned to historical probabilities of return for the S&P 500 index in order to stress the risk of being too conservative.

"Statistically, one-third of the time the market is up more than 10% a year; another third of the time, it's up less than 10%; and the other third, it's negative. It averages out to 10% a year," he said.

"So one-third of the time, you get single-digit returns, another third, you can have double-digit returns and the other third, you lose money.

"With this deal, if it's up a lot, you lose, if it's down, you lose. The only time you make money is with single-digit returns. That's the only way to win. I can't get excited about that."

'Ridiculously low' cap

The two-year buffered product appeared to be better at first, he said.

"The second deal is a little bit better. It's longer, the two-times leverage is fine, and we've got the buffer. If the market is down, I win. If it's up single digits, I win. If the market is up a lot, I lose. At least in two out of three scenarios, I win," he said.

But the cap is the problem, he said.

"The cap is ridiculously low. A 10% cap over two years, that's 5% a year. I can get that type of return investing in a high-yield bond and take a heck of a lot less risk," he noted.

"Why would you lock yourself for two years just to get a 5% to 7% return? I can't do that. There's just not enough upside."

Fees

"The nail in the coffin is the 2% fee. It's incredibly high. This is the S&P, not some wild index nobody ever heard of. I can buy this for less than 10 basis points," he said.

"No wonder your cap is only 10% to 14%. All the money you're spending on the fee eats up your upside potential.

"You should be paying 50 basis points per year. Two percent is a fair fee on a five-year note. On a two-year [note], it's ridiculous.

"For all these reasons, I wouldn't be engaging in any of these offerings."

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