Two dual directional notes linked to S&P point to advisers’ preference for buffer over barrier

By Emma Trincal

New York, June 27 – JPMorgan is pricing two issues of one-year dual directional notes linked to the S&P 500 index on the behalf of two different issuers, allowing advisers to compare the downside payout of each product.

The deals happen to have the exact same terms on the upside. The difference is the nature and size of their respective downside protections. Each advisor preferred the buffer despite its smaller size over the barrier.

The first deal is UBS AG London Branch’s 0% capped trigger dual directional notes due July 15, 2020. They will pay at maturity par plus any index gain, subject to a maximum return of 7%, according to a 424B2 filing with the Securities and Exchange Commission.

The same applies to the second offering – Credit Suisse AG, London Branch’s 0% dual directional buffered notes due July 15, 2020, according to a separate 424B2 filing.

Buffer versus barrier

Both structures are dual directional. If the final index value is negative by less than the downside threshold, investors will get par plus the absolute value of the index return.

But while UBS offers 16.51% contingent protection via a barrier, Credit Suisse offers a 10.5% hard buffer.

As a result, if the index drops 15% in the UBS deal, investors will gain 15%. If it falls 20%, however, they will incur a 20% loss.

Under a 15% market decline, the Credit Suisse notes would generate a 5% loss. However, a 20% price drop would produce a loss only half as big as the other deal.

No alpha

“Obviously none of them is very bullish,” said Steve Doucette, financial adviser at Proctor Financial.

“With both products you’re only long the market for one year if it goes up and you’re capped at 7%.

“I really don’t like either especially on the upside.”

Doucette’s goal when purchasing structured notes is to be able to outperform the underlying not just on one side of the market but both. The impossibility of beating the market on the upside with either one of the notes is what made him find the structure unappealing.

“The only positive thing is this chance to beat the market on the downside with the absolute return,” he said.

“Well, you may outperform the market on the downside, but you may get nothing.

“If you’re outside the absolute return range, there is no value for any of these notes.”

Cushions worth more

He noted the difference in size between the hard buffer of 10.5% and the contingent protection of 16.51%. But the quality of the protection rather than its size was the key factor.

“At least with the 10[.5]% buffer, you are more likely to outperform. You will get up to a 10[.5]% positive return due to the absolute return. But even if it goes down further, you’re still ahead since it’s a buffer,” he said.

“With the barrier, it’s all fine so long as you don’t go down by more than 16.5[1]%. Once you hit the barrier, you’re long the index with a big loss.”

Bearish outlook

Doucette mentioned another drawback. The investment theme for each note was too bearish for his taste.

“You only make money when the market is down. On the upside, you’re capped at 7%,” he said.

“Both notes are very bearish. You’re giving up on the capacity of this market to continue running for another year. We’re already up more than 16% this year – in just six months.”

If he was “that bearish,” he would pick the buffer rather than the barrier, he said.

“I don’t like barriers, and the reason I don’t like barriers is because the average bear market is well beyond 16%.”

Stocks lose 35.68% on average in a bear market, he noted, citing research from Ned Davis on the 25 bear market cycles that have impacted the S&P 500 from February 1928 to December 2008.

Expected values

Jeff Pietsch, head of capital markets at the Institute for Wealth Management, reached the same conclusion but in a different way.

He compared the mathematical expected value of each note and balanced his finding with a suitability criterion.

While the barrier note offered superior value, his clients would be more comfortable with a buffer.

“In general we like those butterfly notes or absolute return. It’s nice to be able to extract a positive return if the index is down,” he said.

“But they have to be constructed properly.

“So here’s the interesting thing: how do you choose between a deep barrier and a buffer which is smaller in size?”

To do that, Pietsch ran a mathematical calculation looking at all the probabilities of possible outcomes for the next year in a range comprised between negative 20% and positive 7%. He used the same range to compare both products.

“If you do the math, the UBS note with its 16.51% barrier has a higher expected value. We found an expected value of over 3% for it while it was only 1% for the Credit Suisse note ... the one with the buffer,” he said.

“So from a mathematical standpoint, the UBS deal would be preferable.”

Rule No. 1

But investing is not limited to probabilities and math.

The client and his or her risk tolerance matter just as much if not more, he said.

“If you are an institutional investor, you would go with the UBS deal, which is worth more on that range. You would take the highest expected value.

“But with retail clients you have to take into account their need for capital preservation.

“When you see how quickly this market has been moving over the past two years ... how easy it is for this market to fall more than 20% as we were reminded between October and December, I would have a preference for the buffer.”

Even if math points to UBS as being a superior product, Pietsch said that he would “lean toward” the hard protection.

“Imagine the disappointment if the market is down 20%. You’d be losing 20% with the UBS note and twice less with the buffered structure.

“For our clients the purpose of structured notes is to provide capital protection, not making a bet on ranges of outcomes.”

J.P. Morgan Securities LLC and UBS Investment Bank are the agents for the UBS notes (Cusip: 90270KF87).

J.P. Morgan Securities and JPMorgan Chase Bank, NA are the agents for the Credit Suisse note (Cusip: 22552FLS9).

Both offerings will price on Friday and settle on Wednesday.

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