Well Fargo's 0% participation notes linked to index, ETFs add transparency, adviser says

By Emma Trincal

New York, Oct. 7 - Accelerated notes tied to a basket of exchange traded funds provide investors with more transparency and liquidity, said Matt Medeiros, president and chief executive of the Institute for Wealth Management in Denver.

"Linking notes to baskets of ETFs is a relatively new trend and one that is very good for investors," said Medeiros.

"We're seeing more and more products linked to ETFs versus options on the indices, and looking forward we will see more of them.

"That's because with ETF-linked notes, you give investors a level of transparency that is very comforting for them. The trick is to make sure the underlying ETFs are liquid enough. It's safe to say that they are in this particular basket."

Medeiros was referring to a planned offering of 0% participation securities with partial principal protection due May 2015 from Wells Fargo & Co., an example of the trend of linking to ETFs.

The Wells Fargo deal is tied to an equity basket that includes the S&P 500 index with a 50% weight, the iShares MSCI EAFE index fund with a 30% weight and the iShares MSCI Emerging Markets index fund with a 20% weight, according to a 424B2 filing with the Securities and Exchange Commission.

Wells Fargo Securities, LLC is the underwriter.

Good use of capital

Using ETFs may represent a cost for the issuer versus the option, said Medeiros.

"It's more expensive for the issuer to use the ETFs because the options could cost them 15 cents on the dollar, while with the ETF they are investing the full dollar."

However, current low interest rates make it easier to structure ETF-linked notes than before, Medeiros said.

When compared to the cost associated with putting together a fully protected zero-coupon structure, issuing partially protected notes allows the issuer to make better use of its capital, he said.

That is because a zero-coupon instrument requires the issuer to set aside sometimes up to 85% of the principal in a cash bucket, using only 15% to buy the options that will give "direction" to the product, he said. "The zero represents a substantial amount of money that sits in cash and remains idle, while with a basket of ETFs everything is invested."

Partial protection

The payout at maturity on the Wells Fargo notes will be par plus 100% to 110% of any basket gain, with the exact participation rate to be set at pricing. Investors will receive par if the basket declines by 20% or less and will lose 1% for every 1% that it declines beyond 20%, in other words, they only enjoy 20% principal protection.

The risks or disadvantages for investors are the lack of interest payment, the possibility of losing 80% of their principal and the fact that their payout at maturity depends on the performance of the basket during the term, according to the risk section of the prospectus supplement.

U.S. and international

Combining U.S. equity and foreign equity in the underlying basket is not uncommon, said Medeiros.

But the trend reflects a view expressed by the banks issuing those notes.

"Mixing two emerging market ETFs and a U.S. stock index in a 50:50 allocation represents a certain outlook on the global economy," he said. "When you issue this note, you have to create an efficient portfolio expressing a view for the next five years.

"Here I think the issuer is saying that we will see a balance in the U.S and foreign markets in the recovery process."

Margin call protection

But Philip Guziec, derivatives strategist at Morningstar, said that he does not really see any intrinsic value in the Wells Fargo product.

"Investors in these notes are essentially long the basket and long a put protection since they can protect up to 20% of their investment. I can't see why you would buy it except perhaps to reduce the risk of a margin call," he said.

Guziec offered the following example, assuming that a hypothetical investor uses leverage to manage his portfolio.

The investor in this example would buy $1 million worth of notes. Assuming that the participation rate is 110%, his equity exposure would then be $1.1 million. With the 20% buffer, this investor can guarantee 20% of his $1.1 million exposure, or $220,000, which represents the protected part of his portfolio and the foundation of his margin call defensive play.

Assuming the margin loan rate is 10%, this investor has then a $100,000 margin balance. But thanks to the put embedded in the note, the $220,000 protected account balance is enough to ensure the investor is in a position to meet the $100,000 margin call.

"That's pretty much the only rationale I see behind this deal. But I still wouldn't do that," said Guziec.

"You can replicate this mechanism - being long the basket and long the put - on your own by buying yourself the protective put on the securities. There is no real reason to incur the transparency cost and the limited liquidity associated with this product," he said.

© 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.