BNP Paribas’ uncapped dual directional notes linked to S&P 500 index offer creative payout

By Emma Trincal

New York, Jan. 7 – BNP Paribas’ 0% dual directional notes due Jan. 29, 2020 linked to the S&P 500 index add a relatively new twist to the typical absolute return structure by applying a less than 100% participation rate to the absolute return feature.

If the index finishes at or above the initial level, the payout at maturity will be par plus the index return, according to a term sheet.

If the index falls but the final index level is greater than or equal to the barrier level, the payout will be par plus 50% of the absolute value of the index return. The barrier level will be set at pricing and is expected to be 57.5% to 62.5% of the initial level.

If the final index level is less than the barrier level, investors will be fully exposed to the index’s decline.

Different

By paying out 50% rather than 100% of the absolute value of the index decline above the barrier, the issuer was able to improve the terms of the structure, advisers noted.

It is uncommon for absolute return notes, also known as dual directional notes, to cut the participation rate of the absolute return below 100%, according to several products reviewed by Prospect News over the past year. But this technique offers the advantage of lowering the barrier and eliminating the cap, sources said.

The majority of those products are capped on the upside. The cap and the barrier tend to be symmetrical, although not always, according to the review. The downside protection is usually between 15% and 25%.

The four-year term with this note is average. When the maturity is shorter, structurers may reduce the protection or link the return to more volatile underliers, according to the data. Even with those additional terms, the cap will remain a key component of the structure.

Beating the market

“This is kind of nice,” said Steve Doucette, financial adviser at Proctor Financial.

“The outperformance on the downside can be huge.”

He offered an example based on a hypothetical barrier of 60%, which is the mid-point of the range.

“You can outperform the benchmark by 60% in theory. That’s tremendous,” he noted.

His reasoning was that a final 40% index decline would give investors a 20% positive return, which represents 60 percentage points above the market level.

One risk may be timing as more and more investors are beginning to anticipate the end of the bull market without knowing how long the ensuing bearish trend should last.

“If the term was a little bit shorter, I may get excited about this note,” Doucette said.

“As we’re entering into the seventh year of this bull cycle with no significant pullback we’re overdue for a bear market adjustment.

“In four years we might have already gone through the bear and be going back up where the protection doesn’t provide any value."

Cost

But the product is still attractive for its capacity to provide alpha, he said.

Structures allowing investors to make money in down markets are likely to gain momentum, he added.

“The market is down 30%. You make 15%. How much of the general investing population could do the same by just buying an index fund?” he said.

“This note essentially gives you a cheaper index exposure with protection.”

According to the term sheet, commissions and fees will not exceed 85 basis points.

“We would still try to negotiate the fee, depending on how much we would invest, but it’s still a pretty cheap market exposure given the huge potential to outperform on the downside.”

Doucette said that the issuer has shown some “creativity” in the way the product has been structured.

Creative

“We’ve seen absolute return notes before, but I haven’t seen it done that way, where you’re getting half of the absolute amount or a portion of it,” he said.

“Thinking creatively, I think that this absolute return component, even at a 50% rate, is huge. I might modify it and give up some of it, for example get 25% instead of 50%, and try to shorten the term and add some leverage,” he said.

“That’s something I may want to take a look at.

“The way the note is structured right now gives you an advantage on the downside only, which is neat. But what if the market tanks and then comes back? You’re just long the index.

“I might even do 20% in absolute return to open up the upside and shorten the maturity even more.

“The index is down 40% and you’re up 8%. That might be an interesting twist, especially if you add some leverage and make it shorter.

“You’re still outperforming and sucking up the majority of that loss. That may be a very interesting parameter we may want to explore.”

More to come

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said products similar to this one may play well in the current market environment.

“I do believe that we’re going to see a lot more interesting structures this year,” he said.

“With the unease in the marketplace and the potential increase in volatility, I believe that investors will be looking for protection through structured notes. It’s going to be an interesting year for structured products.”

He pointed to the “unusual” structure of the notes.

“What’s interesting is that it has no cap and you get the full upside equity participation while you can also make money when the market is down,” he noted.

“Having the absolute return above that barrier is very appealing. Even if you don’t get all of it, it’s still a gain.”

Medeiros said he was cautious about the market. Investments that can outperform the benchmark or provide a hedge against losses should be in greater demand this year.

Risky market

“As much as the market advanced in the last five years, it is now due for a 20% pullback,” he said.

“If you have that 20% pullback and the market doesn’t finish in positive territory, this is a very attractive note.

“People are questioning the strength of the global economy. They’re concerned about protection at this point.

“The Fed is committed to raise interest rates, but I’m not sure that we have the growth to support it.

“You have geopolitical tensions; there is China, oil. There are a lot of factors that contribute to a pretty unstable market environment.

“This structure will be attractive for somebody who uses the S&P as a core component to their allocation strategy.”

BNP Paribas Securities Corp. is the agent.

The notes will price Jan. 26.

The Cusip number is 05579TKJ4.

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