Wells Fargo’s $55.5 million enhanced return notes tied to EM ETF have unusual leverage feature

By Emma Trincal

New York, Sept. 3 – Wells Fargo & Co.’s $55.5 million of 0% enhanced return securities with 1-to-1 upside and downside exposure and threshold leveraged upside participation due Sept. 6, 2019 linked to the iShares MSCI Emerging Markets exchange-traded fund caught market participants’ attention for the contingency of the leverage structure.

Investors will get one-to-one participation in any loss as well as a one-to-one participation in the fund’s gain up to a threshold level, 111.9% of the initial price, according to a 424B2 filing with the Securities and Exchange Commission.

If the final level is greater than the threshold level, investors in addition to 111.9% of par will receive 1.5 times leveraged participation in the appreciation of the underlier beyond the threshold level.

The leveraged return, explains the prospectus, only applies to gains above the threshold level, not to – as is usually the case – gains above the initial price and the below the threshold.

Contingent leverage

“This is sort of new. It’s interesting,” said Steve Doucette, financial adviser at Proctor Financial.

“You’re getting leverage only if the return after four years is 12%, which is not much and doesn’t require being very bullish. So it’s a different kind of leverage. If you meet the condition, it’s very attractive because you outperform the index and it’s not capped. The no-cap component is key.”

He noted that a buyer of the notes would need to have a view on the length of the next market cycle, which is almost impossible to predict.

Timing

“The question is, will a secular bull market continue?” he said

“If we run into a bear market, you may not be able to average your 3% a year for four years. It sort of depends on when the bear market hits. If it hits early enough, four years may give you enough time for a bounce back, in which case you may get to the 12% level you need to get to. But who knows?”

Investors are at risk if the fund is down at maturity. If it appreciates by less than the threshold, there is no loss but an opportunity cost is incurred since there is no reason to invest in the notes versus owning the shares, he said.

“If it closes below 12%, you’re just long the index with a one-to-one upside and no downside protection. In that case, the notes offer no value.”

His main concern was the unlimited downside exposure.

“I don’t think I would buy it because I would need the protection. But I may come back to the issuer and see under which conditions I could get some sort of a barrier or buffer,” he said.

“I really like the fact that it’s going to outperform even if the index is not up by a lot though. That’s the appealing part. Getting the plain return plus uncapped leverage over 12% is pretty attractive. It’s a new concept, a new type of structure, and it’s worth looking into it.”

Delta one plus call

A market participant said he was intrigued by the structuring of the product. He described it as follows: The issuer offers one-to-one exposure up to the threshold, or “delta one.” Beyond that, a partial call is struck at the upper strike, which he rounded up to 112% versus the exact term of 111.9% stated in the prospectus.

“They’re going long a 100 strike call and short a 100 strike put. That’s the standard delta one structure,” he explained.

“Above the 112 strike, you’re also long a 0.5 call strike at 112; you’re long an out-of-the money call.”

The call is said to be “out-of-the-money” because the current ETF level at pricing, or 100, is below the 112% call strike.

For any price increase above the 112 call strike, investors receive 50% of the return, based on this methodology.

“With your one-time at-the-money call with a 100 strike all the way up plus half-a-call with a 112 strike, you get just that: 100% upside up to the 112% strike plus 150% above that level,” he said.

“The numbers work out. Obviously the terms are attractive,” he noted based on the deal size.

“The question is, where do they get the money to price it?”

Pricing

One part of the money available to price the structure would naturally come from the unpaid interest rates, the “Wells Fargo spread” for four years, he said.

But this would not be enough as the client is buying volatility and there is no cap, he added.

“For the 100% participation, the delta one, it’s a wash. The one-time long call and one-time short put cancel each other out. They’re both at-the-money, both at the same strike. That’s the equivalent of buying the ETF shares.

“But you still have to purchase half a call. The investor is long volatility, and volatility is higher.

“There are two factors that make the pricing feasible.

“First, the upper call strike. It’s only half a call, and it’s at a higher strike. A higher strike option trades at a lower premium. If you buy a call way out of the money, it’s going to be cheaper because the option is less likely to be exercised.”

Still, the structurer of the notes had to pay the premium in order to purchase the half-a-call.

“Aside from the interest rate and the spread, it comes from dividends,” he said.

Investors in the notes have to forego dividends on the shares of the underlying fund. This particular ETF pays a 2% dividend yield, or 8% over the four-year time horizon.

Value

“You have 8% in leftover value. That should be enough to buy half a call option struck at 112,” he said.

The risk-adjusted return of the notes suggested that investors had to be pretty bullish to buy the product.

“If you compare this to a standard leveraged note, with the typical leveraged product you get the juice of the leverage right away. Here, you have to give it up for the first 12%. The leverage benefit only kicks in at a higher strike. That’s why you need to be very bullish. You forgo any acceleration for the first 12% if you think the index is going to be above that and hopefully way above that. That’s when you get the extra 50% participation.”

There was a reason for structuring the leverage that way, he said.

“Most structures with 1.5 leverage would cap the upside. They don’t. That’s the whole point of giving you conditional leverage at a higher threshold.”

The notes (Cusip: 94986RYN5) priced on Aug. 31.

Wells Fargo Securities, LLC was the agent.

The fee was 3.9%.

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