Wells Fargo’s notes tied to Russell 2000, S&P 500 seen as an attractive equity substitute

By Emma Trincal

New York, June 30 – Wells Fargo & Co.’s market-linked securities due July 8, 2021 that are callable with contingent coupon and contingent downside linked to the Russell 2000 index and the S&P 500 index offer an attractive potential coupon given the level of risk incurred by investors, buysiders said.

As a result, the notes could find their place in an equity portfolio as a substitute for a long-only position, they added.

The notes will pay a contingent quarterly coupon at an annual rate of at least 7% if each index closes at or above its coupon threshold level, 60% of its initial level, on the observation date for that quarter, according to a 424B2 filing with the Securities and Exchange Commission.

The notes are callable at par on any quarterly observation date after one year.

The payout at maturity will be par unless either index finishes below its 50% downside threshold level, in which case the payout will be par plus the return of the worse performing index with full exposure to any losses.

Good deal

“I’ll be honest with you, I actually like this deal,” a portfolio manager at a buyside firm said.

“For a good portion of the next five years anything like a 7% return is going to look pretty attractive especially with all the stuff going on in Europe...being able to collect that kind of return is pretty good.”

While the coupon is conditional and not fixed, the chances or earning it over many quarters were seen as significant due to the low barrier level. As long as the worst performing index does not drop more than 40%, investors receive their payment, he noted.

In terms of principal at risk, the likelihood of not losing money was also high.

Solid barriers

“I don’t think you’re going to hit the barrier quarterly or at maturity,” he said.

He calculated the barrier levels based on Thursday’s approximate closing level of the S&P 500 at 2,100.

For an investor not to receive coupon, the index would have to fall below 1,260. A loss of principal at maturity would only occur if the index fell to 1,050, or 50% of its current level, he said.

“Think of what needs to happen to get there. If we get there, we’ll have worse things to worry about,” he said.

Call, worst of

Predicting the conditions, which would lead the issuer to call the notes, was not easy. But the probability of the call to occur was seen as high.

“You’re more likely to get called than to lose principal,” he said.

“You’ll probably get called if the issuer found a cheaper way to get funding.”

Even with the worst-of payout, this buysider said the risk-adjusted return was attractive given the high correlation between the two underliers, the low barriers along with the coupon size.

“It’s a very aggressive deal in my opinion. And look, even if you hold the notes for a year and on the first year they call you, you still make 7% in one year. Not bad.”

Yield and real yield

Investors in the notes do not receive dividends. Yet, the coupon remained competitive in his view.

The dividend yield for the S&P 500 index is approximately 2%. It is 1.5% for the Russell 2000.

“With 7% you’re doing three-and-a-half times better than the S&P yield. You’re doing even better than the Russell,” he said.

On a real rate basis, the contingent interest rate was also very “aggressive,” he noted.

The five-year forward inflation expected rate, which the Federal Reserve uses to predict inflation over a five-year period, is 1.44%, he noted.

“That’s very low. If you take that away, it means you have a 5.56% real yield on this paper. I think this is a pretty good deal,” he said.

New normal

Steve Doucette, financial adviser at Proctor Financial, also found the yield to be very competitive.

“Seven percent is obviously not bad in this market environment,” he said.

“Everyone is resetting return expectations to the new normal.

“As we approach new highs in this market, your return isn’t going to be 8% to 12% in the next five years. At best it’s going to be 4% to 7%.

“You’re looking at 7%, which would make for a reasonable equity substitute.”

The probability of collecting the coupon over a great number of quarters was seen as high as well.

“How long are you going to be below a 60% barrier and not collect the coupon? You might miss a few coupons but you’re still going to collect for a while.

“And then what are the odds that you finish down more than 50%? It’s not very likely especially after five years.”

Call: the wildcard

What could really put an end of the coupon payment would be a call from the issuer.

“The only thing with this note is the discretionary call. You don’t know really when they’re going to call you and why,” he said.

“If they call you, you stop collecting the coupon obviously.

“The call introduces the uncertainty. The coupon is contingent based on the barrier level. But it’s more a function of if they call the notes and when.”

The duration of the notes had to be considered too.

Investors are subject to the credit risk of Wells Fargo over a relatively long period of time.

But Wells Fargo is one of the best credits among U.S. banks, he noted, adding “it limits the risk.”

His main concern regarding duration was how to value the notes in the secondary market given the unpredictability of the discretionary call.

Price discovery

“If the market is down, you won’t get called. As long as you don’t breach the barrier you still collect. But if we have a bear market you may want to get out,” he said.

“These structured products are liquid. We sell them all the time. I’m just curious though about the price I would get if I wanted to sell before maturity.

“Let’s say we’re two years into this note and the market is down 39%. What’s the range I can sell it out? I have three more years to go. Am I going to get 50 or 65 cents on the dollar? I have no idea and I would be curious to know. I guess it depends on how many years are left. It also depends on whether you’d want to cash it out, as I do, or whether you’re willing to roll it over. You’ll get a better bid in a rollover. These are very key questions you need to know before you invest.”

Part of his preference for “cashing out” was to use the proceeds “to buy on the dip in a bear market,” he explained.

In the opposite scenario – if the market rallies – the issuer is likely to call the notes, he said.

“In the rally scenario, things are less complicated. They call it. I get my money back. The market is up and I’m happy to redeploy into equity.”

Wells Fargo Securities LLC is the agent.

The notes will price on Friday and settle on July 7.

The Cusip number is 94986RQ53.

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