Barclays' $123 million notes tied to Russell offer high coupon but principal seen at risk

By Emma Trincal

New York, Oct. 26 - The $123 million sale by Barclays Bank plc of autocallable knock-out buffer notes tied to the Russell 2000 represented a remarkable deal in terms of size, sources said, attributing the success of the transaction to investors' appetite for high-yield product that can be earned in a very short time.

High coupon

"People are attracted to this product hoping that the notes will get called. It's only a nine-month term. If your notes get called after only three months, you make 7% return in three-month and you get your principal back. That's pretty good," said Suzi Hampson, structured products analyst at Future Value Consultants.

The main appeal of this autocallable note is its potential for high yield, said a structurer.

"When you compare a potential 7% return in nine-months or less with a one-year Treasury yielding only 40 basis points, it makes sense why the deal would be so popular," said the structurer.

Barclays' 0% autocallable index knock-out buffer notes due July 29, 2010 linked to the Russell 2000 index will be called at 107% of par if the index closes at or above 107% of its initial level on any review date, or the first trading day of each week, according to a 424B2 filing with the Securities and Exchange Commission.

The notes provide the opportunity to participate in the appreciation of the index, subject to the maximum return of 7%, according to the pricing supplement.

While the popularity of the notes is easy to understand given the high coupon, investors should not lose sight of the downside risk, said Carl Kunhardt, director of investment management and research at Quest Capital Management in Dallas, who focused his criticism on the buffer embedded in the structure.

"It's a good deal for Barclays. And I am surprised they could sell that much," he said. "Somebody did not read the prospectus," Kunhardt said.

Atypical buffer

Kunhardt focused on the worst-case scenario, when the barrier is breached, which is when the index declines by more than 20%. In such a case, investors will lose 1.00% of the principal amount of their notes for every 1.00% the final level of the index has decreased compared to the initial level, according to the filing. As a result, if a knock-out event occurs and the index loses 100%, investors will lose their entire principal, according to the filing.

"I don't see why anybody would do this," Kunhardt said. "This tells me that if the knock-out even occurs, you might as well own the index because you're fully participating to the downside and not on the upside."

Kunhardt said that the buffer described in the prospectus did not function like a typical buffer.

"With most buffers, let's say if you take the example of a 20% buffer, when the underlying is down 35%, you only lose 15%, or the difference between the index decline and the buffer. But it doesn't look like it's occurring in this structure. Once your barrier is breached and you're down 35%, then your capital will lose the entire 35%. You lose point to point for every point of decrease of the index, regardless of the buffer. In this case, if your index declines by 35%, instead of losing only 15%, you lose your entire 35%," he said.

"I don't understand why you would put your entire principal at risk while your return is capped on the upside," said Kunhardt. "After all your appreciation - if any - is limited to the 7% coupon."

For bulls only

But the notes make sense for "investors that are a bit bullish," said the structurer.

He said that the best-case scenario is when the notes get called and the investors earn the high 7% in a very short time.

But even in the absence of a call, this structurer said that investors benefit from some fair amount of downside protection, as long as the barrier is not breached. According to the filing, investors may earn a minimum 2% return even if the index declines. The only condition is that the barrier is not breached. For instance, if the index is down 10%, investors will still earn a 2% return, according to the filing.

Volatile underlying

Kunhardt said that such bullish bets are not worth the risk of being fully exposed to the decline of the index, because there is always the possibility of losing one's entire principal when the index breaches the barrier. A 100% decline for instance would wipe out the entire investment, he said.

Kunhardt said that the risk of breaching the barrier is not small given the choice of the underlying index. The Russell 2000 is a commonly used small capitalization index of the U.S. equity market.

"With small caps, it's easy to see a 20% loss anytime within a nine-month period," he said.

Retail likely

Despite the fact that the size of the deal - at about $124 million - was exceptionally large and that the fees set at 0.65% were low, some sources speculated that the deal must have been sold to individual investors.

"I guess it's all retail," said the structurer, declining to elaborate.

"I'd be surprised if institutions bought that because they would have read the prospectus," Kunhardt said.

JPMorgan Chase Bank, NA and J.P. Morgan Securities Inc. are the agents.

The deal priced on Thursday and will settle on Tuesday.

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