Deutsche's variable-rate notes could draw cautious investors with ratchet, capital protection

By Kenneth Lim

Boston, April 17 - Deutsche Bank AG's planned variable-rate notes linked to a basket of equities have an unusual structure that could attract cautious investors, said structured products analyst Suzi Hampson of Future Value Consultants.

Deutsche, through its London branch, will offer principal protected variable-rate notes due April 30, 2014 linked to an equally weighted basket of 15 common stocks. The stocks are Apple Inc., AT&T Inc., Chevron Corp., Cisco Systems, Inc., the Coca-Cola Co., Exxon Mobil Corp., General Electric Co., Google Inc., International Business Machines Corp., Johnson & Johnson, JPMorgan Chase & Co., Microsoft Corp., the Procter & Gamble Co., Verizon Communications Inc. and Wal-Mart Stores, Inc.

The notes will pay a variable coupon every year. The first coupon payment is fixed at 1.5%. The second coupon payment will be the higher of zero or the basket contribution. Subsequent coupons will be the higher of the previous coupon payment and the basket contribution.

The basket contribution will be the sum of 1/15 of each component's annual contribution. If a component has closed at or above a cap of 9% to 10% on any observation date, the component's annual contribution will be the cap. If the component closes below a floor of minus 25% on the relevant observation date and has never closed above the cap, the component's annual contribution will be the floor. Otherwise the component's return will be its annual contribution.

The exact cap will be set at pricing.

Investors will receive par at maturity.

Complex structure

The product is unusual on a few fronts, Hampson noted.

"[There are] a lot of elements to it in comparison to the majority of products, which are fairly simple," she said.

First, the basket has 15 stocks, which is rather high in the United States. The five-year maturity is also on the longer end of the spectrum here, while the variable coupon is seldom seen. That variable-rate feature may be especially attractive in the current market, she added.

"It's something investors are looking for, principal protection and income, now that rates are low, and one way is to get a variable-coupon scheme," she said.

The ratchet feature is also an uncommon inclusion, and because it locks in the upside, it can be costly for the investor, Hampson explained.

"I'm guessing if they didn't have a lock-in, they could maybe have a higher cap or not as much of a floor," she said. "It does seem to be quite an expensive tactic."

The product would be quite difficult to price in a secondary market, Hampson said.

"As far as all the elements together, it'd be quite difficult to price this," she said. "You could do it, but the more elements a product has, the more variation there would be in the price. If you go to five different banks and asked them to price this, you'd get something different."

Cautious product

The notes could be attractive to risk-averse investors, Hampson said.

"It seem to be quite a cautious investment because it's got principal protection, and you've got 15 stocks, which averages out the changes in each stock, and the lock-in factor, so if they perform well in the first year, and everything goes downhill from there, you'll still get your coupon," she said.

Those investors could also be seeking an annual income, she said.

"Most income products we see are not capital protected, so this is more cautious," Hampson said.

Long-term savings

Longer-dated products also benefit from a slight amount of cost savings, Hampson explained.

"There's a certain amount of fixed cost in setting up a product," she said. "If you've got a three-month product and a 1.5-year product, the three-month product could have some of the same costs as the 1.5-year product. So when you split that out over the maturity, it's spread out over 1.5 years, whereas if you buy a three-month reverse convertible and you buy four of it over a year, you're paying those costs four times a year."

Some of those cost savings are reflected in Future Value's analyses of structured products, Hampson said. A glance at recent research notes by the firm show that longer-dated products tend to have better overall ratings. One of the higher-rated reverse convertibles that the firm recently rated, a 10% annualized reverse convertible by Barclays Bank plc linked to the common stock of Hewlett-Packard Co., also has a one-year maturity - relatively long for reverse convertibles.

"It doesn't mean you're not going to earn as much return as the others, it just means you're paying the costs over the maturity," Hampson said.

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