Wells Fargo’s digital return barrier notes tied to S&P 500 may offer fixed-income substitute

By Emma Trincal

New York, Sept. 20 – Wells Fargo & Co.’s 0% market-linked notes with contingent fixed return and contingent downside due Oct. 2, 2023 linked to the S&P 500 index give investors a fixed return no matter what the performance of the underlying is as long as it’s not negative. With a downside protection deep enough, some advisers may use it as a fixed-income replacement strategy.

If the index finishes at or above its initial level, the payout at maturity will be par plus a contingent fixed return of 35% to 40%, according to a 424B2 filing with the Securities and Exchange Commission.

If the index falls by up to its 60% threshold level, the payout will be par.

Otherwise, investors will lose 1% for each 1% decline.

Steve Doucette, financial adviser at Proctor Financial, said the notes would not be a pure bond replacement for lack of total protection. But it would be more appropriate to allocate it to a fixed-income rather than an equity portfolio.

Better with bonds

He first explained why he did not see the notes as an equity substitute.

“Your upside is capped at 7% or 8% a year. It’s not bad. After all there are a lot of gurus out there saying that we’re at the final stages of the bull and that we shouldn’t expect more than 7% or 8% a year looking forward,” he said.

“But it’s complicated. The market is crazy high again. The Dow just hit a new record today. Over five years we could go down and pull back up.

“I don’t think I like it as an equity replacement and that’s just because the upside is limited.”

While investors do not get income during the life of the notes, the investment is more of a fixed-income strategy, he said, given the fixed payout and the substantial downside protection.

“It won’t go up more than 7% or 8%. But in a fixed-income allocation, 7% or 8% is pretty good.

“The 40% barrier is pretty deep too.”

Statement shock

However, clients seeking income tend to be conservative. Over five years, the valuation of the notes will oscillate based on the underlying performance.

“I like it as a fixed-income replacement. The only downside is that it doesn’t pay anything until the end. In the meantime, if we get into a bear market even for a short while, the valuation of these notes can go down,” he said. “That’s when people look at their statements and begin to worry. You have to hold their hand and explain that they need to wait until maturity. Easier said than done.”

No cap is better

Jerry Verseput, president of Veripax Financial Management, said that while he likes digital notes in general he tends to pick the uncapped kind, which this one is not.

“I prefer those digitals where you get at least a fixed return and if the index goes up more than that, you’re just long the index without a cap. I like these a lot,” he said.

Sometimes branded as “market-linked step up” or “trigger jump securities” depending on the underwriter these structures however have become lately more difficult to structure, he said.

“Those are really my favorites because you don’t limit your upside,” he said.

“But they’re not pricing well at least when tied to the S&P. That’s why I don’t hesitate to go out from five to six years. That extra year makes a big difference. You can pick up very large incremental benefits,” he said.

Insurance

But digital products, like the one announced by Wells Fargo tend to pay a higher fixed return, he said.

“That’s the trade off. You’re capped but you’re capped higher than those, in which you’re allowed to participate,” he said.

“You have to ask what is it you’re trying to accomplish here because you’re really giving up that upside.”

Perhaps the most valuable component of the structure was its protective barrier.

“If we see a recession in the next two or three years, that would be a real nice note,” he said.

“It’s an insurance against recession. That’s what I would call it.

“You’re willing to give up the upside for that 7% to 8% a year in exchange for a deep level of protection.”

Stay put

A long maturity was required to price such a barrier. Verseput said he had no problems with longer-dated notes.

“A lot of the time, people want to stay short term because they want to time the market,” he said.

“If you think your timing is good, good for you. You shouldn’t be in the notes.

“When you buy a note, especially a five- or six-year note, it takes the need to time the market out of it.

“A structured note allows you to adopt a buy-and-hold approach knowing that you have a 40% downside protection.

“This is why I think this one is pretty decent.”

Wells Fargo Securities LLC is the agent.

The notes will price on Sept. 27.

The Cusip number is 95001B6K5.

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