Wells Fargo’s leveraged market-linked CDs tied to Euro Stoxx raise concerns amid market sell-off

By Emma Trincal

New York, Oct. 26 – Wells Fargo Bank, NA’s 0% market-linked certificates of deposit due Oct. 31, 2023 linked to the Euro Stoxx 50 index offer upside leveraged participation and full principal protection at maturity, two features investors may find appealing in today’s volatile market.

But for some, the product would not be safe enough in a down market. These concerns were aggravated on Friday as global markets fell sharply, raising fears of a bear market looming.

The five-year tenor of the CDs raised the question of liquidity as some market participants questioned the timeliness of locking their money up without receiving any income or dividends. They pointed to the risk of not earning any gain at the end if global markets enter a phase of turbulence.

The payout of the CDs at maturity will be par plus 115% to 125% of any index gain, according to a term sheet with the exact participation rate to be set at pricing.

“This index has been trading range bound over the past two years. It hasn’t done much,” said Tony Romero, co-founder and chief executive officer of Suncoast Capital Group.

Over the past five years, the euro zone benchmark has been relatively flat, up 2.2%. But the index can show sharp drawdowns such as between March 2015 and June 2016 when it dropped 22.5%.

CDs versus fund

When compared to an exchange-traded fund, the notes do not offer any dividends. The index yields 3%.

The CDs may offer an alternative to an ETF but not an opportune one in all scenarios, said Romero. The upside leverage is one advantage of the structured product over ETFs as leverage applies only to the upside unlike a leveraged ETF, which would amplify losses by the same factor as it would magnify gains. The 100% principal protection against market risk and credit risk is also a critical benefit offered by the market-linked CDs.

However, The Euro Stoxx 50 index has to appreciate enough to offset the loss of dividends over a five-year term and make the CD worthwhile, he noted.

0% interest

For income investors, which constitute the bulk of Romero’s clientele, the main objections would be the absence of income payment during the life of the product and the uncertainty associated with an equity-linked payout.

“You may get paid more than an income investor in a regular CD. Or you may get no gain at all,” said Romero.

“Your only return lies in the performance of the index five years from now. You’re speculating that the index will be up then. But it could be 50% higher or 50% lower. Anyone telling you where the index will be in five years is speculating.”

Interest-bearing CDs

Romero prefers traditional CDs that pay a fixed coupon especially as interest rates are moving higher.

“We see a lot of credit union CDs that are federally insured as well with very competitive rates,” he said.

From bank-issued CDs Romero is actually showing a Wells Fargo Bank five-year brokered CD at 3.5%. “It’s a new issue coming early next month,” he said.

“You’re getting paid monthly and you’re getting 17.5% guaranteed after five years instead of hoping and guessing.”

Investors may even take advantage of the flat shape of the yield curve to get nearly similar rates on shorter maturities, he added.

The same issuer for instance is offering a two-year CD at 3.05%, a three-year at 3.20% and a four-year at 3.45%, he said.

Volatility rising

Full principal protection is good to have, a market participant said. But participating in the downside would be better.

“The global environment I think is not good enough to justify tying up your money for five years without getting anything in the interim,” he said.

“With Brexit, the trade wars, the international market outlook is not that rosy right now.

“There are too many issues in the market that make me feel uncomfortable putting new money to work at this point.”

He was making those comments on Friday when the Dow dropped 300 points and the S&P 500 index entered correction territory.

The Euro Stoxx 50 index dropped 1% on Friday. Since the beginning of the year, this index has lost 11%.

“The U.S. is going to bring down the rest of the world,” he said.

Even the five-year tenor of the CDs doesn’t guarantee any positive outcome at maturity for the Euro Stoxx 50, he noted.

Invisible bear

“People often say: we will have a bear market now and then there will be enough time for a recovery,” he said.

These assumptions may not materialize, he warned, as unpredictable factors are at play, such as the amplitude of the losses, the length of the bear cycle and the strength of the rebound if there is one during the period.

“Let’s assume we’re now entering a bear market. We have a 20% decline for the next two years. That’s 40%. How quickly does it take for the market to rebound? How much return do you recover from the down years?” he said.

Overall, the main risk associated with the CD was liquidity.

“You’re not being compensated for the risk of getting nothing and your money is tied up for five years,” he said.

“I’d much rather invest in a dual directional structure at this point. At least you get to participate in the downside.”

Incapital LLC is the distributor.

The CDs will settle on Oct. 31.

The Cusip number is 94986T7E1.

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