Barclays’ digital notes tied to S&P, Stoxx, oil & gas ETF add too much risk in the asset mix

By Emma Trincal

New York, Aug. 9 – Barclays Bank plc plans to price 0% digital notes due Aug. 12, 2021 linked to the least performing of the S&P 500 index, the Euro Stoxx 50 index and the SPDR S&P Oil & Gas Exploration & Production exchange-traded fund, according to a 424B2 filed with the Securities and Exchange Commission.

If each underlying asset finishes at or above its 65% barrier level, the payout at maturity will be par plus the digital return of 44%.

Otherwise, investors will be fully exposed to the decline in the worst performing asset.

Inverse correlation

A market participant noticed the use of three rather than the more common two underliers in this worst-of.

“It’s a way to increase the risk and therefore capture more premium,” he said.

“You need all three to close above the barrier to get the booster, not just two,” he said.

If the three underliers had been three broad-based equity benchmarks the risk would have been more contained. But the use the SPDR S&P Oil & Gas Exploration & Production ETF in the mix made it more likely that at least one of the three underliers would breach the barrier.

“By adding this ETF closely correlated to oil, you’re introducing something negatively correlated to the equity indices. If the price of oil goes up, the energy stocks in the ETF will do well but it may be a negative for the overall equity market.”

The extra risk generated by a third underlier and one closely tied to commodities, whose correlation with stocks can be negative allowed the issuer to price the deal on better terms.

“You’re adding more risk so you can boost the digital or increase the protection with a lower barrier,” he said.

“It looks like they did a little bit of both.”

Mixing asset classes

While both the digital payment and the low barrier appeared attractive, this market participant called for caution.

“I’m not a fan,” he said.

“Keep in mind that clients are retail investors. Maybe 5% of them understand correlation risk.

“If you’re going to increase the risk by adding a third underlying, especially one with a bigger correlation divergence, I think it’s a bit too much of explaining to do.

“Clients look at the economics of a deal. But having them understand the risk takes work.

“You’re throwing in there another asset class...commodities along with equities. I think that adds a lot of correlation risk.”

While the ETF is an equity fund tracking the return of oil producers, its correlation to the underlying oil and gas commodities was very high, making it almost a proxy for oil.

Same sector plays

“I’d much rather see two or three assets, even stocks...in the same sectors...like three energy stocks or three bank stocks.

“In this offering they’re mixing asset classes...you’re betting on equity and you’re betting on oil. We know they can move in opposite directions, which really increases the chances of breaching the barrier.

“I would personally shy away from his note,” he said.

Yield alternatives

Andrew Valentine Pool, main trader at Regatta Research & Money Management, was not interested in the correlation risk either. In general he avoids worst-of altogether.

“If you want good yield, energy stocks is a good place to be. But I would go for a note tied to a basket of energy stocks rather than this,” he said.

Pool said he does not like investing in notes with more than one underlying, let alone, three.

“This deal is already an outlier compared to the typical worst-of with two indices. Here there are three.

“That’s a lot of uncertainty,” he said.

“If only one of them drops 39% you lose 39%. Just one out of three...That’s very risky. This is why we don’t do worst-of.

“If I had to do one of those worst-of, I would use the S&P and the Russell where you have more correlation.”

But even with only two underliers instead of three and more correlation between the assets, Pool said he still would not use worst-of products from a risk management standpoint.

“Regardless of how they’re set up, we don’t like them because you can’t model your risk. When you don’t know in advance what your exposure is going to be, it makes it very difficult to hedge it.”

Barclays is the agent.

The notes will settle on Aug. 16.

The Cusip number is 06744CGH8.

© 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.