Wells Fargo’s leveraged notes linked to S&P 500 index offer no cap, compromise for mild bulls

By Emma Trincal

New York, Feb. 10 – Wells Fargo & Co.’s 0% market-linked securities due March 7, 2022 with leveraged upside participation and contingent downside linked to the S&P 500 index offer a high potential return and good pricing for investors with a moderately bullish view on the market, said Suzi Hampson, structured products analyst at Future Value Consultants.

“These notes are for the average bullish investor. They offer some protection and no cap, but investors have to be in for five years, and they don’t get a very high participation rate,” said Hampson.

The payout at maturity will be par plus 125% to 135% of any index gain, with the exact participation rate to be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

In order to generate her research report, Hampson picked the mid-range value of 130%.

If the index finishes at or above its 70% downside threshold, the payout will be par.

Otherwise, investors will receive par plus the return with full exposure to losses.

“You’re not getting a lot of leverage. But the barrier is pretty generous even though you’re still at risk of losing your capital,” she said.

Not having a limit on the upside is one of the most valuable features of the notes.

“For investors willing to take on some risk, you’re looking at a pretty good risk-adjusted return,” she said.

No dividends

As with most structured notes, investors are not entitled to receive dividends. The S&P 500 yields 2%.

Over the five-year term of the notes, investors must forgo a 10% return, without taking into account compounding.

The break-even point at which noteholders having exposure only to the price return would do better than the equity investors would be a 7.7% return over the life of the notes.

“Anything above that, you’re benefiting from the gearing. Below that, you’d be better off with the index,” she said.

Middle ground

More leverage would have helped. “But leverage is expensive,” she said.

Because of that, the notes are not aimed at the most bullish investors.

“They would want a higher participation rate, and they wouldn’t waste money on the barrier,” she said.

Instead, potential buyers would seem to have a more risk-averse profile, preferring a good barrier to more upside leverage. For those, the trade-off is a longer maturity, which means more credit risk exposure and giving up more in dividends.

“This note is somewhere in the middle ground. You have leverage, and you still get protection against those chunky losses. But it’s not for the top bullish investors even though there is no cap,” she said.

Risk

Future Value Consultants assesses risk, return and value using proprietary scores in order to compare a product with others. Comparisons are made with two groups: same product type and all products.

In this case, the product type is leveraged return.

Risk

The firm calculates the market risk and the credit risk and adds the two components to generate the “riskmap.” This score measures on a scale of zero to 10 the risk associated with a product with 10 as the highest level of risk possible.

The notes have a 2.50 market riskmap versus an average of 1.42 for the same product type. But compared to all products (market riskmap of 2.63), the notes have a market risk that is “slightly lower than average.”

“The greater risk compared to similar products is probably a reflection of what we’re looking at. We may have notes with a shorter maturity, which in our system comes out as less risky because you have fewer chances of hitting the barrier,” she said.

Credit

The credit riskmap is 0.40, compared to the 0.28 average for leveraged return notes and 0.38 for all products.

The higher credit risk is due to the longer exposure to the issuer’s credit risk even if Wells Fargo has the tightest credit spreads among large U.S. banks, according to Markit, at 49 basis points.

JPMorgan shows the second tightest spreads with 58 bps, according to the financial information service company. Meanwhile, Bank of America and Citigroup have spreads of 67 bps and 68 bps, respectively. Morgan Stanley shows 82 bps and Goldman Sachs, 85 bps.

The riskmap, obtained by adding the two components, is 2.90 versus an average of 1.71 for the same product type and 3.01 for all products.

High return score

Despite this higher risk level, the notes score “very well” on Future Value Consultants’ risk-adjusted return metric called return score. A score of 10 represents the best risk-adjusted return. The rating is computed based on the best among five market scenarios, which in this case would be bullish.

The return score is 8.82 versus an average of 7.40 for similar products and 6.53 for all products.

“It’s very good,” she said.

“Our return score is based on the ideal market scenario: bullish. With that in mind, any uncapped product, especially over a long tenor, will do very well on the return scale.

“The return score is risk-adjusted. In spite of the relatively high riskmap, if you assume a bull market and remove the cap, the further away you go, the higher return you may expect.”

The choice of the market assumption contributed to reduce the negative impact of risk.

“If the index goes up, the chances of finishing below the barrier are lower.”

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.

This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

At 8.74, the price score is nearly in line with the average for the same product type of 8.84. Compared with the 7.07 average for all products, the notes offer a higher value.

“You would expect this kind of product to price higher because it’s competitive,” she said, referring to the underlying index, which is widely traded and whose options are highly liquid.

“The cost should be less, and it is less.

“If you had a complex product with an exotic underlying, you would expect to pay more for the issuer to put it together.”

Finally the maturity helped to reduce the cost since fixed costs calculated per annum are spread over a longer period of time.

Overall

The overall score, which is the average of the price score and the return score, measures the firm’s opinion on the quality of a deal.

The notes have an overall score of 8.78 versus 8.12 for the average leveraged return note and 6.80 for all products.

Leveraged notes with longer maturities and no cap produce some of the best scores based on Future Value Consultants’ methodology, she said.

That’s because of the use of the best market assumption to calculate the return score. Between bearish, bullish, low-volatilely environment, high-volatility environment and neutral, the obvious pick is bullish.

“Investors expect those leveraged notes to grow. Our assumptions are based on what’s best.

“Obviously, a bullish market growing over time with no cap on the upside is going to score well.

“Our underlying assumptions support that.”

Wells Fargo Securities LLC is the agent.

The notes will price on Feb. 28 and settle on March 7.

The Cusip number is 94986R4H1.

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