Wells Fargo’s buffered leveraged notes tied to MSCI EM offer short-term play for mild bulls

By Emma Trincal

New York, Nov. 14 – Wells Fargo & Co.’s 0% buffered enhanced return securities with capped upside and buffered downside due Feb. 23, 2016 linked to the iShares MSCI Emerging Markets exchange-traded fund offer an attractive valuation, according to a research report from Future Value Consultants.

The payout at maturity will be par plus 1.3 times any gain in the fund, up to a cap of 18.07%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the fund falls by up to 10% and will lose 1.1111% for each 1% decline beyond 10%.

Downside gearing

“We have a maximum return of 18% for the one-year and a quarter, which is just under 14% annualized. The index doesn’t have to go as high as that. On an annualized basis, it only needs to be up not even 11% to get to that level,” said Tim Mortimer, managing director at Future Value Consultants.

“On the downside, up to a 10% decline, you still get the protection. Then off of that, it’s a 1.11 downside leverage factor, the maximum leverage you can put in there with a 10% buffer so that it eventually will go down to zero, worst case scenario.

“Obviously this creates more risk, therefore more value. With that gearing on the downside, you can generate a bit of extra return on the upside. The gearing by adding more risk on the downside helped the issuer to offer a slightly higher cap.”

The extra value was more likely to have been used to enhance the return than to add more protection.

“The 10% buffer on the downside looks OK for a short-term note. It would be excellent for an S&P product. But with an emerging markets fund, it’s not worth that much. Add those two risk factors – the gearing and the volatility of the fund – and you can certainly play with the cap and raise it a bit.”

Given the structure, the notes are aimed at investors whose outlook is not extremely bullish, he said.

“You still have to be bullish to reach the maximum return. But to get to 18%, the fund needs to go up by 14%. Since it’s not a one-year but a year and a quarter term, the leverage is going to enhance the return because you’re talking about a 10% annual growth in emerging markets, a volatile asset class that a truly bullish investor can expect to go up much higher than that,” he said.

The value of the notes was one of the highlights of the report.

Good value

For each product, Future Value computes a price score that measures the value to the investor on a scale of zero to 10.

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 notes showed an 8.58 price score compared to 7.63 for the average of the same product type, which is “leveraged return.”

The category includes all notes with an upside participation rate greater than 100%.

“It’s significantly higher, which means the issuer spent more on the assets. It’s very competitive compared to the market. It could be because it’s a relatively plain-vanilla product on a significantly popular underlying,” he said.

“This very good price score is also interesting given that it’s a very short term product. Usually short durations go against you when it comes to the price score because we look at the fees on an annualized basis and so you have less time to spread the fees,” he said.

This factor did not impact the score negatively, he noted, saying that liquidity helped pricing.

“It’s easier to trade options on a shorter term basis. An option for a one-year period is going to be more liquid than for a five year,” he said.

“The S&P is still liquid on the longer end, but for that fund, that’s not true.

“By shortening the maturity, they’re tapping into easier hedging and therefore lower costs.”

Return score

On the other hand, the return score, which measures, on a scale of zero to 10, the risk-adjusted return, was slightly lower than average, according to the report.

The notes have a 7.45 return score versus 7.75 for the average for the same product type.

“The return score is a little bit down compared to the average,” he said.

This rating is computed based on five key market assumptions – neutral assumption, bull and bear markets, and high and low volatility environments. The research firm calculates the score using the best among the five return scenarios, which for this particular product would be the bullish assumption.

“We have a very positive value and a less impressive return score. Usually when the price score is high, you expect the return score to be high too,” he said.

The gap may simply be the result of the structure, he explained.

“Because our return scores are based off certain scenarios, having a cap in there over a relatively short period of time doesn’t really give you the chance to see the full effect of the bull market on your return. It would be different with a longer-dated, uncapped leveraged product. Those types of products benefit much more from a bullish scenario,” he added.

“That said, the return score is not that much lower. The risk-reward of the product is still very healthy.”

Less risky than peers

The notes show a relatively less risky profile than their peers, according to the report.

Future Value Consultants measures risk on a scale of zero to 10 with its riskmap, with 10 the highest level of risk possible.

The riskmap is the sum of two risk components: market risk and credit risk.

The report shows a 2.76 riskmap for the notes versus 3.30 for the category.

The credit riskmap is particularly lower than average at 0.22 compared to 0.56, respectively.

“It’s a very low credit risk score. That’s a combination of the short duration and the issuer itself. Wells Fargo has a very low credit risk,” he said.

The market riskmap was also lower at 2.54. The average was 2.74.

“The buffer helps reduce the market risk. Despite the gearing, a buffer is better than a barrier, which will take you all the way down from the initial price when breached. We’re comparing this product against all types of leveraged notes, many of which have a barrier or even no protection at all.”

Overall score

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

At 8.02, the product shows an overall score higher than the average of 7.69.

“It’s an extremely solid product,” he said.

The notes (Cusip: 94986RVF5) will price and settle in November.

Wells Fargo Securities, LLC is the agent.

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