Wells Fargo’s notes linked to real estate ETF show solid buffer, but sluggish market is a risk

By Emma Trincal

New York, Jan. 22 – Wells Fargo & Co.’s 0% market-linked notes due Feb. 2, 2021 linked to the iShares U.S. Real Estate exchange-traded fund offer a sizable buffer and “decent” upside, but there is a risk of underperforming the fund in a muted performance scenario as the leverage may not offset what noteholders have to give up in high income.

The payout at maturity will be par plus 200% of any ETF gain, capped at par plus 20%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the ETF falls by up to 31% and will lose 1% for each 1% decline beyond 31%.

High income

Investors in the notes must forgo the dividends paid by the fund. For noteholders, the trade-off is giving up the high income associated with real estate exposure. The iShares U.S. Real Estate ETF has a 3.5% dividend yield.

“You’re giving up 7% in two years to get 20%. And you get 30% in downside protection. It seems reasonable to me,” a market participant said.

However, investors would be better off building the structure themselves with options, he added.

He described the various “legs” of the equivalent options strategy.

“You own the shares long, and you buy an at-the-money call. That takes care of 2x upside,” he said.

An at-the-money call is one where the call strike is identical to the price of the underlying ETF. For each point of increase above the initial price, investors gain one point from the shares and one from the call, hence the two-times factor.

Do it yourself

Investors are “capped out” at 20% above the initial price, which is the strike price for the sale of two “out-of-the-money” calls, he continued. The calls are out of the money since the underlying price is below the strike price.

The downside payout consists of the simultaneous sale of an “out-of-the-money” put 31% below the initial price and the purchase of an at-the-money put. Combined, the two options provide the buffered protection up to 31% on the downside with a one-to-one loss beyond the buffer level, he explained.

“If you were to put that together, you’d probably get a slightly better deal,” he said.

“It’s a nice structure, but you could do it on your own.”

Protection

For those who can’t do it on their own or are not inclined to do it themselves, the deal offered a very attractive level of protection, he conceded.

The upside was designed for moderately bullish investors.

“You’re not too bullish, but you’re hoping to pick up the 13% on the upside,” he noted.

He was referring to the net maximum return after dividends.

“What’s really interesting is the 30% buffer. REITs are very expensive.”

Chart

The underlying ETF offers exposure to U.S. real estate companies and REITs, which invest in real estate directly and trade like stocks.

The iShares U.S. Real Estate ETF share price closed at $79.43 on Tuesday.

The ETF was at its10-year low back in March 2009 at around $22.00 a share. Growth was substantial up until 2013 but has stagnated since then.

“You may need that protection two years from now. If rates are up, you could get hurt,” he said.

Flattish performance

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, did not think giving up the dividends offered an attractive trade-off to noteholders.

“If you’re giving up the yield, you’re giving up the whole reason to invest in real estate in the first place, which is the above-average income,” he said.

Chisholm is not bullish on real estate in general.

“This is a 20% cap, which you’re unlikely to get. We haven’t seen these levels since 2007. This ETF has been flat for a number of years, and I don’t see any reason to expect the asset class to excel in the next couple of years,” he said.

Underperformance likely

“The buffer is nice, the leverage is nice, but I really don’t see the benefit of giving up 7%, especially if the performance is flat,” he said.

A range-bound market when one gives up a high yield is at the core of the risk associated with this investment, according to Chisholm.

“The price has to increase above a certain breakpoint for the note to be worth more than a direct investment in the underlying ETF. If the return is above the breakpoint, the note is better. If it’s below, the ETF is better. I’d rather buy the shares outright.”

Breakpoint

The breakpoint is around 7% over the two years. If the underlying increases by less than 7%, investors would be better off owning the shares and pocketing the dividends, he explained.

A price return of 7% would generate a 14% gain for the notes with the two-times leverage. The dividends paid by the fund would provide an identical return for shareholders. Below the breakpoint, noteholders would be at a disadvantage.

“I really don’t see that type of growth. This is an asset class that hasn’t been able to break out of its range for years.

“I don’t expect REITs to do particularly well.

“If you’re bullish on real estate, you should be buying it for the income.”

The average annual total return over the past three years has been 3.85% for this ETF, according to iShares website data as of Dec. 31.

Wells Fargo Securities LLC is the agent.

The notes will price on Monday.

The Cusip number is 95001BCC6.

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