Longer tenor of Barclays' trigger notes linked to Vanguard FTSE EM ETF presents pros, cons

By Emma Trincal

New York, Feb. 6 - Barclays Bank plc's 0% trigger performance securities due Feb. 28, 2019 linked to the Vanguard FTSE Emerging Markets exchange-traded fund have an attractive structure with enhanced, uncapped upside and downside protection. But investors have to be comfortable with the five-year duration, sources said.

If the ETF return is positive, the payout at maturity will be par of $10 plus 125% to 135% of the return. The exact participation rate will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the ETF return is zero or negative and the final share price is equal to or greater than the trigger level, 75% of the initial share price, the payout will be par.

If the final share price is less than the trigger level, investors will be fully exposed to the decline in the fund from its initial share price.

Secondary market value

For Steve Doucette, financial adviser at Proctor Financial, the issuer offers a fair structure, but the term is too long, especially for investors who need to be able to redeem early.

"We don't buy a five-year note necessarily to hold it for five years," he said.

"I like the basic structure, but when you go out five years, there is so much uncertainty.

"With emerging markets, a 25% contingent barrier is not that big a deal. So much can happen between now and then, between the ups and the downs. I don't see the value of a 25% protection five years out."

The long duration combined with leverage may not be advantageous from a valuation standpoint, he said.

"My real issue is with the five-year tenor. If the market is up 25% a year or so from now, you're not going to fully value the options if you sell early. You're not going to get 125% leverage. You're going to get less than that. And if you go up that high, the protection is useless" he said.

"If we were up 30% after three years and levered up, I would take some of the risk off the table and reset the protection.

"You need to reset the protection because the outperformance you've earned when the fund went up is going to unwind down when the market changes direction. If there is a big move on the upside, we know that the market is going to come back down, and it may get ugly."

Getting the right price of the notes on the secondary market is always more difficult when there is leverage, he explained. And the longer tenor makes predictions all the more complex.

"The flip side with leverage is that it's not worth much until you get close to maturity. The optionality component is never going to be valued at the full leverage level. So the question is, do I want to take what could be a levered downside scenario off the table and reset the protection level? We try.

"For instance, we recently had this trade ... the market was up 20%. We had 1.5 times. It gave us 30%. We closed down 27%."

To get the full value of leverage, noteholders must hold on to the securities, which may not always make sense from an investment standpoint, he explained.

"If your emerging market goes through the roof next year, that leverage is not worth anything until you go through the next four years," he said.

"And where emerging markets is going to be in five years? No one knows. Too much can happen in five years.

"The basic structure is very sound. My only concern is the duration."

Good timing

Jim Delaney, head trader at Market Strategies Management, said that the five-year duration could turn out to be beneficial for investors. But they must agree to buy and hold the notes.

"Right now, emerging markets are at a pretty good place to buy," he said in reference to the sharp sell-off that has hit this asset class since last fall.

"We're already down. And you get protected up to a 25% decline. If the fund is down 26%, you lose 26%.

"Based on today's valuations, if it's down 26% five years from now, we wouldn't be talking on the phone. ... We'd be in the streets with guns.

"Whatever gyrations we're going through today in emerging markets, everything is out of the way in five years."

While five years "is a long time," the duration can also yield a high return given the fact that there is no cap, he reasoned.

No upside cap

Delaney offered an example with a hypothetical participation rate of 130%.

"You're getting 30% more of what the return is. You're giving up the coupon, fine. But if the fund is up 30%, you're up 40%. That's 2% a year right there. If you can get a five-year paper that can give you 2% a year, people would be jumping all over," he said.

"The only negative I see is that you have to be willing to lock funds up for five years.

"But at the same time, I suspect that the five-year [term] will give you a greater probability of coming up with a positive return or a higher positive return."

The Vanguard FTSE Emerging Markets ETF has lost 7.30% since the beginning of the year. Over the past five years, it has gained 61%.

"If you were up 61% five years from now, you would get a 79% return. The bigger the numbers, the more the leverage works in your favor," he said.

"The longer duration gives you a higher probability of getting outsized returns."

UBS Financial Services Inc. and Barclays are the agents.

The notes are expected to price Feb. 25 and settle Feb. 28.

The Cusip number is 06742K873.

The fund invests in stocks of companies located in emerging markets around the world such as China, Brazil, Taiwan, and South Africa, according to Vanguard's website. Its goal is to closely track the return of the FTSE Emerging index. Vanguard is the investment adviser to the fund.

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