Wells Fargo’s notes linked to Energy Select SPDR fund offer buffered exposure to risky sector

By Emma Trincal

New York, Oct. 7 – Wells Fargo & Co.’s 0% market-linked securities with leveraged upside participation to a cap and fixed percentage buffered downside due May 7, 2020 linked to the Energy Select Sector SPDR fund offer a “generous” buffer, but risk is still high given the volatility of the underlying asset class, said Tim Vile, structured products analyst at Future Value Consultants.

The payout at maturity will be par plus 170% of any fund gain, subject to a cap that is expected to fall between 33% and 38% and will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the fund falls by up to the 15% buffer and will lose 1% for each 1% decline beyond 15% if the fund finishes below the buffer.

“Ignore the underlying. When you see those terms this looks like a pretty good product. You have a cap of more than 35% over three and a half years, a decent buffer, 1.7 times leverage. If it was the S&P, it would be flying off the shelves. But it’s not. The underlying index price can move a lot, which creates significant risk,” he said.

Future Value Consultants evaluates risk, return and price using a variety of proprietary scores in order to compare a product with others, including its peers. For his report, Vile assumed a mid-range cap at 35.5%.

“This is an alternative to a direct investment in the fund for investors who seek exposure to the energy sector. Your upside is capped, but you have some protection. However, just because you have a buffer doesn’t mean this is for conservative investors. It’s not because you’re exposed to a volatile asset class. You need to understand the energy sector to buy the notes,” he said.

Cap

The annualized cap with the leverage would represent 9% a year. To hit this level, the fund would only need to increase by 5.55% a year, or nearly 21% during the period.

“The annual return is quite good, and it’s based on a reasonable growth in the index. One could argue that 5.5% is pretty easy to achieve when you buy an energy fund. Because it’s so volatile, if it’s up, you are very likely to hit the cap,” he said.

A more bullish investor would probably want a higher cap, “something more ambitious,” he said.

“There is probably room to raise the cap if you change the nature of the buffer. A geared buffer for instance would allow you to do that. But by the same token, you would change the risk profile of the investment, making the notes even less suitable for conservative investors.”

In any event, a buffer “definitely should be in place” for this type of underlying, he noted.

The Energy Select Sector SPDR fund, which is a stock ETF, has gained 17.5% this year. But from its July 2014 peak to its February low, the fund lost nearly half of its value.

Risk

The firm calculates the market risk and the credit risk of a product and adds the two components to generate the “riskmap,” which measures on a scale of zero to 10 the risk associated with a product with 10 as the highest level of risk possible.

The notes have a 3.37 market riskmap versus an average of 1.75 for the same product type. The product type in these ratings is leveraged return. It is defined as any note with an upside participation rate superior to 100%.

“It’s double the average risk. Despite a 15% buffer in place, the volatility makes it more likely to hit that threshold,” he said.

“Energy and oil prices are hard to predict. They rely a lot on supply and demand, and therefore, they depend on geopolitical events, which tend to be unpredictable. This makes the asset class more volatile even though we’re dealing with equity.”

On the other hand, the notes show a relatively low level of credit risk.

The credit riskmap is 0.33, which is below the average for the product type of 0.46.

“Even though this is still a reasonably long product, you find in the U.S. many longer products, especially among leveraged return structures. So that’s a plus. On a relative basis, your credit risk exposure may be shorter here,” he said.

But the main factor, he added, is the creditworthiness of the issuer. Wells Fargo continues to be among the best credits in the United States.

Wells Fargo indeed had credit default swap spreads of 61 basis points on Friday, according to Markit.

In comparison, Bank of America and Citigroup have spreads of 81 bps; Morgan Stanley, 93 bps and Goldman Sachs, 97 bps. Only JPMorgan with spreads at 63 bps is close to Wells Fargo’s levels, according to Markit.

The riskmap, when adding the two risk components, is 3.70, compared with the average of 2.21 for similar products and 2.04 for all products.

“The lower credit risk helped, but not enough. We still have an elevated level of risk,” he said.

Return score

The return score measures the risk-adjusted return of a note. It is computed based on the best among five market scenarios. In this case, the score derives from a bullish market assumption.

The return score is 7.49 versus an average of 7.45 for similar products and 7.16 for all products.

“This is a good return score, and it’s interesting. Having a pretty high risk level and a cap, you would think you’re in trouble. But that’s not the case, and we can assume that the cap level is still relatively competitive,” he said.

“Under a bullish scenario and given how volatile the underlying is, you have a pretty good chance to hit the cap. Since it’s about 9% a year, you’re getting a good return.”

Value

The pricing of the notes in contrast disappointed.

For each product, Future Value Consultants 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.

At 7.12, the price score is significantly lower than the average for the same product type of 8.76.

The term of the notes is intermediary, but longer products are plenty in this category. As a result, the lower price score may partially be due to the relatively shorter duration, he explained. That’s because longer products enjoy more time to amortize the fees calculated per annum, which enhances their price score.

Another factor may be the underlying itself, which is less frequently traded than the S&P 500. That may suggest less competition for pricing, he said.

Also when an underlying is more volatile, a bank may take a higher profit margin to cover its hedging costs, which could impact the price score as well, he noted.

“They probably could have spent more on the options, maybe raise the cap a little bit given the risk or increase the size of the buffer or both. These things would have given a little bit more value to the product.”

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.

The notes have an overall score of 7.31 versus average scores of 8.11 for leveraged return notes and 7.76 for all products.

“This is very much lower. Unfortunately the return score drags down the overall. Certainly the risk level is quite high. The terms look good though. But the volatility associated with the underlying requires an investor who knows the sector quite well and who is willing to take the risk,” he said.

Wells Fargo Securities LLC is the agent.

The notes (Cusip: 94986RX89) will price Oct. 31 and settle Nov. 7.

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