Wells Fargo’s leveraged notes linked to S&P 500 aimed at cautious, mildly bullish investors

By Emma Trincal

New York, Jan. 22 – Wells Fargo & Co.’s 0% buffered enhanced return securities with capped upside and buffered downside linked to the S&P 500 index give investors the potential to generate double-digit returns in a moderately bullish market. The presence of a buffer makes the structure more appealing to conservative investors as well, said Tim Vile, structured product analyst at Future Value Consultants.

The notes are expected to mature 22 to 25 months after settlement, with the exact maturity to be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

If the final index level is greater than the initial index level, the payout at maturity will be par plus double the index return, subject to a cap of 18.6% to 21.8%. The exact cap will be set at pricing.

Investors will receive par if the index declines by 10% or less and will lose 1.1111% for every 1% that it declines beyond 10%.

Vile generated his research report using the shorter end of the duration range, which is 22 months. For the cap, he used the mid-point of the range at 20.2%. Using those terms, the payout structure gives investors a maximum annualized return of 10.6% on a compounded basis.

Upside

“With the two-time leverage the index only has to rise by 5.52% to hit the cap, which is not huge,” he said. “You get some good leverage, and the cap is quite reasonable, especially on the S&P 500 index.”

The notes also offer an interesting profile on the downside.

“You have a 10% buffer in case the index drops,” he said.

“The downside gearing accelerates your losses and eventually, worst-case scenario, you can lose all your investment instead of 90% of it with a normal buffer.

“But the gearing enables the issuer to show better terms because the additional risk gives you more premium, which can be used to buy more leverage.

“Getting a decent cap on the upside with a buffer is the best of both worlds. It’s not always possible to achieve that combination over a short-term deal.

“Recently, we’ve noticed that terms in general have improved in relation to the higher volatility in the market.”

Investors in the notes do not anticipate the market to be as bullish as it was over the past few years up until last summer. At the same time, they do not foresee a bear market either.

“If you don’t expect the market to rise by more than 5% a year, you’re not very bullish,” he said.

“Yet, you need to be bullish because the market still has to rise.

“This is the typical trade for a moderately bullish investor who wants to get market exposure but is still cautious.”

In its research, Future Value Consultants assesses risk, return and price using a variety of proprietary scores in order to compare a product to others.

Market risk

For risk, Future Value Consultants calculates the riskmap, which measures the risk on a scale of zero to 10 with 10 as the highest level of risk possible. This measure of risk is the sum of two risk components, market risk and credit risk, which are both calculated on the same scale.

The notes have a 2.11 market riskmap versus an average of 3.98 for the product type, according to the research report.

This note belongs to the leveraged return product type, according to Future Value Consultants’ classification.

“The buffer really helps here. A 10% buffer on a two-year based on the S&P is quite competitive even if it’s a geared buffer,” he said.

“It’s not as good as a non-geared buffer, but you’re still better off than with a barrier because the amount of losses is still contained. With a barrier, once there is a breach, you no longer have any protection.”

Another risk-reducing factor is the use of the S&P 500.

“The underlying is not among the most volatile benchmarks, and it’s certainly less volatile than a stock, a sector fund or some international equity index,” he said.

Credit risk

The product also has a low credit risk, according to the report, showing a 0.26 credit riskmap versus an average of 0.49 for the product type.

“Wells Fargo has very tight spreads, which explains the low credit risk. In addition to that the less than two-year maturity reduces your exposure to a credit event or default,” he said.

On Friday, Wells Fargo’s five-year credit default swap spread was at 60 basis points, according to Markit.

In comparison, Goldman Sachs and Citigroup showed spreads of 102 bps, Morgan Stanley, 101 bps, Bank of America, 92 bps and JPMorgan, 81 bps, according to the financial research provider.

Return

Future Value Consultants produces a return score to measure the risk-adjusted return of a product. It is calculated based on the best among five hypothetical market scenarios, which for this particular product would be the bullish scenario.

The return score is 7.69 versus an average of 7.32 for similar products and 6.89 for all products, according to the report.

“It’s a very good risk-adjusted return. It’s mainly due to the lower riskmap. Also the cap appears to be relatively strong. There is still a cap, but it is quite high,” he said.

Value

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10. The score measures the value to investors and is reduced by the amount of fees. Fees are calculated on an annualized basis.

At 8.90, the price score is higher than the 7.37 average for category, the report showed.

“It’s very good. You wouldn’t expect that on a short-term note because there is less time to amortize the fees,” he said.

“And yet the score is really good, meaning that pricing is very competitive.

“It’s the result of the competition between banks when pricing deals on the S&P index, one of the most widely used underlying.

“But clearly, the score mainly suggests that this issuer spent enough money on the options in order to provide good value to investors.”

Overall

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

The notes have an overall score of 8.29 while the average for the product type is 7.35. The all-product category shows an average of 6.68.

“This is a decent score. It’s the result of a combination of terms – a 10% buffer, a short maturity, a well-known, liquid index, some reasonable leverage and a cap that can deliver double-digit returns,” he said.

“This note could be a good option for a cautious investor who would seek short-term exposure to the market. The leverage is here to boost returns, assuming that the days of big gains in the stock market are behind us.”

Wells Fargo Securities LLC is the agent.

The notes (Cusip: 94986RD65) will price and settle in January.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.