Wells Fargo's notes linked to S&P 500 feature averaging to enhance pricing, analyst says

By Emma Trincal

New York, March 4 - With its upcoming 0% upside participation equity-linked notes due April 7, 2020 linked to the S&P 500 index, Wells Fargo & Co. was able to offer investors "good pricing" through the use of an averaging feature, said Suzi Hampson, structured products analyst at Future Value Consultants.

The payout at maturity will be par plus the greater of the index return and the minimum return, which is expected to be 2% to 4% and will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

The final index level will be the average of the index's closing levels on the last trading day of each March, June, September and December from June 2013 through March 2020.

Minimum return

"You get 103% after seven years. Principal protection is difficult to price at the moment. Interest rates are very low, funding is really tight, and volatility is falling. One of the ways to make the options cheaper is to do averaging," she said, adding that the 103% level was hypothetical.

"We have a principal-protected product with a little minimum return. It's quite conservative."

Two of the attractive features of the product are the absence of a cap and the minimum return, she said.

She compared the 1.56% yield of a seven-year Treasury with the 3% minimum return.

"It's not very high, but it's still higher than the risk-free rate," she said.

"This minimum return is there to address one of the objections some investors have when they buy principal-protected notes. They have to hold the notes for a long period of time and they have to take the risk of a zero return at maturity. The minimum return takes care of that. It addresses some of the inflation risk too. It may compensate you a little even though it's not much."

But investors "obviously" would not buy the notes just for the minimum return, she said.

"That's not the aim of the product. This is a very bullish note with a medium- to long-term outlook. There is no cap, so you want as much price increase as possible. It's for the bullish investor who doesn't mind holding the notes for seven years. Seven years is longer than the average principal-protected notes. It's quite a big deciding factor," she said.

Even with a long tenor, pricing a principal-protected note with a minimum return and no cap had to be "challenging," she said.

Averaging

"This is why they introduced the averaging. The issuer calculates the value of the index each quarter and they do the average. It's different from the typical point-to-point calculation," she said.

"If the index goes up, your return will be lower than if it was a point-to-point option.

"In some cases, if the index declines, you'd be better off with the averaging.

"The problem with the note, one of its less attractive aspects, is that you really benefit most from the averaging when the index declines. So this feature would actually be more helpful with a capital-at-risk product than with a principal-protected note like this one where you don't care about market risk.

"You definitely want the index to grow if you invest in the notes. But the averaging feature will take away some of this growth from you. So it's a bit of a negative."

Another possible drawback of the averaging feature, she noted, was its complexity.

"For investors used to investing in capital-protected bonds, it's quite hard to understand. It introduces a certain degree of complexity that is akin to comparing a barrier throughout the life with a final barrier, for instance. These are concepts that are quite hard to grasp," she said.

However, the benefit of averaging is the lower cost of the options.

"Chances are that without the averaging, the issuer would have had to either put a cap or eliminate the minimum return or both," she said.

Low riskmap

The riskmap, a Future Value Consultants rating, reflects the risk associated with the product on a scale of zero to 10. The higher the riskmap, the higher the risk of the product. The riskmap is the sum of two risk components: market risk and credit risk.

The 1.28 riskmap "is much lower" than the average of the same product type at 2.87, she said.

This is a combination of a lower market risk and lower credit risk, she added.

"You have less market risk because we measure the market riskmap based on the potential loss compared to cash. We look at losses below Libor rates. Since this note is going to return at least 103%, you're going to lose less against cash than the typical principal-protected note that gives you almost always 100. That's why the market riskmap is higher," she said.

The notes scored 0.35 on the market riskmap scale, compared with 1.28 for the average of principal-protected products.

The credit riskmap for this product at 0.94 is also much lower than the average of the same product type at 1.58.

She pointed to the five-year credit default swap spreads for Wells Fargo of 71 basis points.

"It's much tighter than many other banks," she said, citing the five-year CDS spreads of Morgan Stanley (142 bps) and Bank of America (125 bps) as examples.

Price, overall

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios. In this case, high growth is the best market assumption.

The 8.14 return score is about the same as the average similar product at 8.11, she noted.

"The return score is risk adjusted. Because you have a lower risk, you would expect a lower return. The score is average, which indicates that given the risk, this is an acceptable return. It's a good value product for the investor," she said.

Future Value Consultants measures a note's value to the investor on a scale of zero to 10 via its price score. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The price score is 9.87 versus 8.87 for comparable products.

"It's very good. The high score indicates that the product offers good value and that the issuer spent a lot on the options. It's priced aggressively. It's a good indication that the fees are not too high," she said.

Part of the high price score is also due to the long duration.

"To compute the price score, we look at annualized costs. If you have the long duration, the cost is spread out on the seven-year period, which helps if you compare this to a one-year for instance," she said.

"The average price score is usually higher on the longer-dated product."

Future Value Consultants offers its opinion on the quality of a deal with its overall score. The score is simply the average of the price score and the return score.

"This product scores very well," she said.

"It has a 9.0 overall score, which is higher than the average similar product at 8.49. Compared to its peers, you're looking at a principal-protected note that's very competitive in that category with an aggressive pricing."

Wells Fargo Securities LLC is the agent.

The notes are expected to price March 28 and settle April 3.

The Cusip number is 94986RNV9.

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