Wells Fargo's quarterly capped CDs linked to S&P 500 offer limited opportunity for bull ride

By Emma Trincal

New York, April 2 - Wells Fargo Bank, NA's 0.5% quarterly capped certificates of deposit due Oct. 31, 2017 linked to the S&P 500 index offer an alternative to fixed-income products or variable annuities, sources said.

But investors should be aware of the limited potential upside due to the capping formula and, as a result, should not consider the CDs as a pure equity play, the sources added.

Interest will be payable semiannually, according to a term sheet.

The payout at maturity will be par plus the greater of zero and the sum of the returns on the index for the 22 quarters making up the life of the CDs. The quarterly returns will be subject to a cap of 3.25% to 5.25%. The exact cap will be set at pricing.

Protection

Carl Kunhardt, wealth adviser at Quest Capital Management, said the notes could be used as a form of insurance against downside risk.

"It's attractive particularly for a bearish client because at least you have an opportunity for an equity return," he said.

"I would buy it. It protects your downside. If the market went into the tank, you wouldn't lose anything.

"The only issue I have is that you're locking it up for five and a half years."

The notes should not be recommended to very bullish investors. "You wouldn't keep up with the momentum," he said.

At the same time, very bearish investors would not find the notes appealing given the risk of earning no equity-based return at maturity.

"Can another 2008 happen again? Yes. Is it likely? No," he said.

"I'm taking next to no risk for the potential of equity returns. The price to pay for that is the quarterly cap and locking in my money for five and a half years. If you're not overly bullish and not extremely bearish, I think it's attractive," he said.

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said that investors should not have overly high expectations of equity returns when investing in the CDs. But the product may offer interesting alternatives to conservative investors.

"It's not a bad offering. Your returns are based on equity," he said.

"While it's a different animal than a variable annuity, it's reminiscent of that.

"They pay 0.5% in fixed interest. A five-year CD is approximately 1.8%. So you give up 1.3% for an opportunity to earn a lot more than that."

Quarterly cap

However, the quarterly capping can pose a significant problem, he said.

"If you have a very strong rally, even if you hit your cap, you're not going to participate even close to what the market did," he said.

He assumed a "generous" quarterly cap of 5% and looked at some of the past years' quarterly returns on the benchmark.

"In 2008, everything was negative, so your return would have been zero," he said.

He found that in 2009 and 2010 investors applying the cap formula described in the term sheet would have obtained a return of only 4% and 3.6%, respectively.

For fixed-income investors, the CD is a fine product, he said. But investors should not anticipate getting benchmark-like returns, he said.

"In a strong bull market, while everybody else shoots the lights out, you will do rather poorly. Yes, performance is linked to the S&P, but these caps will significantly reduce your participation in the index. There is no downside protection on a quarterly basis," said Kalscheur.

Tony Romero, co-founder and managing partner at Suncoast Capital Group, said it is possible to imagine a product yielding no return at maturity aside from the 0.5% annual coupon.

"The effect of capping quarterly returns, even under the most generous scenario of 5.25% as opposed to 3.25%, has the potential to significantly impair the return of what otherwise may have been a positive result for the investor," Romero said.

"A particular negative quarter could skew the return negatively in a significant way and for a long period of time.

"They take away the good quarters and give you full exposure to the losses with no floor. They do that for each quarter. You could make the point that it's possible to end up with a negative return - which for you would be zero return - just because the caps on the gains won't allow you to offset the series of negative quarters."

Romero said a point-to-point payout would be "more beneficial" to investors instead of breaking it down into quarters and capping.

"With that quarterly cap, the investor must get lucky 22 times rather than only once," he said.

Kalscheur agreed that a point-to-point cap would have been better for investors.

"The longer you go, the lower the volatility will be. Highs and lows will even themselves out. The shorter the time period you calculate the cap, the more likely you are to hit that cap," he said.

"Look at it this way: There are multiple times when the S&P 500 has been up more than 5% in a single quarter. With this quarterly capping, you'll be nowhere near S&P."

Lowering expectations

However, as long as prospective buyers understand the limitations of the product, the CDs may be appropriate for conservative investors seeking income, Kalscheur said.

"This is not a good fit for an equity investor. This is a CD with a little bit of an extra kicker," he said.

"You're getting a 0.5% coupon. That's not much, but at least it's something. That gives you this S&P option with some potential upside. If you're already considering a five-year CD, it may be a viable option.

"I would just warn a client that this is a fixed-income investment. I would sell bonds to fund something like this, not equities. You want to temper people's outlook. These caps can really make a difference in an overall return."

The CDs (Cusip: 949748P27) are expected to price April 25 and settle April 30.

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