Deutsche Bank’s annual review notes linked to S&P 500 to outperform in range-bound market

By Emma Trincal

New York, Oct. 29 – Deutsche Bank AG, London Branch’s 0% annual review notes due Nov. 2, 2017 linked to the S&P 500 index are designed for mildly bullish investors who don’t expect a severe market downturn two years from now, sources said.

The structure, they added, offers an attractive call premium, but the protection drew less enthusiasm.

The notes will be automatically called at par plus a call premium if the index closes at or above the initial index level on Nov. 10, 2016 or Oct. 30, 2017, according to an FWP filing with the Securities and Exchange Commission.

The call premium is expected to be 9.9% for the first call date and 19.8% for the second call date.

The payout at maturity will be par unless the final index level is less than 90% of the initial level, in which case investors will lose 1% for every 1% decline below the initial level.

S&P autocall

Most autocallables are linked to single stocks or exchange-traded funds, according to data compiled by Prospect News.

Also, the use of the S&P 500 as a standalone underlying for an autocallable is less common. Issuers instead will look for a more volatile index, such as the Euro Stoxx 50 or the Russell 2000. Alternatively, they may use several indexes to build the autocallable using a worst-of payout.

Since the beginning of the year, 14 autocallable notes linked to the S&P 500 have been issued, according to the data. Their average maturity is 1.5 years, and the average call premium is 8.5%. Many of the one- or two-year notes have 10% protection. In some other cases, they have no protection at all.

Downside

Steve Doucette, financial adviser at Proctor Financial, explained that he could not use the notes the way he normally employs autocallables.

“You’re exposing yourself to a lot of downside,” he said. “The 10% protection isn’t much. Most autocalls have much larger barriers.

“You buy this note to collect your premium, and 10% a year is kind of neat on the S&P.

“The question is, how much upside are you willing to give away to get protection on the downside?

“We use autocallables to replace fixed income, and we try to get decent coupons. The last thing we want to do though is be long the equity on the downside. Since 10% can be easily breached, we would give up some of the upside to lower the barrier if we were to look into that.”

Range bound

The market outlook of an investor interested in the product would have to be somewhat “narrow,” he said.

“If you’re using this note, you believe that the market is going to be moderately up but not up by more than 10% a year on the upside. If you’re right, you’ll outperform the index,” he noted.

“If the market is down, at least you have the 10% protection. But you need to assume that the market won’t fall by more than 10%.

“It’s a range-bound view, and you’d better be right.”

Uncertainty

While investors do not have to be very bullish – they get called on the observation date and receive the coupon even if the index return is flat – they do have to worry about a market decline, he said. In a down market, investors may be unable to collect any coupon and their principal is at risk at maturity.

“The real uncertainty on these notes is the timing of them. What’s the market going to be like two years from now? Where are we in the market cycle? A lot of that is going to depend on the world economy because a lot of S&P companies are large international companies,” he said.

Plan B

“When I look at the downside risk, I’m not comfortable with those range-bound two-year notes. You can easily take a hit. We haven’t seen a bear market correction in six years. It could happen tomorrow. And if we’re down 20%, it’s a long way to go back up or even back to negative 10%.”

Doucette said he would have to revisit the structure to make it suitable for his clients.

“I would much rather bring the coupon down and get a 30% or 40% protection even if I may have to go three years out,” he said.

“Now what’s a reasonable coupon for that type of tradeoff? I don’t know. We’d have to see how notes price out today.”

Caution

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said the upside is attractive but perhaps not worth the risk.

“It’s an interesting note in that it’s a two-year tenor,” he said.

“I like the S&P 500 in there. My expectations for the next two years appear to be the low single digits.

“As a result, the economics of this note in a flat or slightly up market make sense.”

But Medeiros objected to the size of the barrier.

“The low return expectations are primarily due to consistently high valuations as it relates to the S&P. Therefore, the potential of it breaking the 10% barrier is pretty good.

“I think the note is interesting in the upside. However, from my perspective, I would have preferred a much deeper barrier.”

Reducing the coupon for a stronger protection, as Doucette suggested, is an option.

“I would also consider being long the index if the return is positive with a deeper barrier,” he said.

“You’re definitely taking some risk on the downside. This note cannot be positioned as an income alternative. It’s a better return than a high-yield bond or some other higher-yielding notes, but you’re taking some serious risk being exposed to all the volatility of equities.”

JPMorgan Chase Bank, NA and J.P. Morgan Securities LLC are the placement agents.

The notes will price Oct. 30 and settle Nov. 4.

The Cusip number is 25152RT37.

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