Deutsche Bank's $61.43 million knock-out notes tied to Dow Jones Euro Stoxx 50 for risk-takers

By Emma Trincal

New York, May 17 - Deutsche Bank AG, London Branch sold via JPMorgan Chase Bank, NA and J.P. Morgan Securities Inc several large-size offerings of 18-month knock-out notes linked to the Dow Jones Euro Stoxx 50 index amid the sell-off seen in the European stock market, sources said.

The European equity benchmark lost 20% since mid-April as a result of the eurozone and Greek debt crisis. It is down more than 23% year to date.

Yet, the offerings were large in size as investors were attracted by some potentially high returns the structure offered under certain conditions, sources said.

A $61 million deal

With a $61.43 million deal, Deutsche Bank brought to market the largest of such offerings last week with 0% knock-out notes due Nov. 16, 2011 linked to the Dow Jones Euro Stoxx 50 index, according to a 424B2 filing with the Securities and Exchange Commission.

If the index falls below 50% of the initial index level on any day during the life of the notes, the payout at maturity will be par plus the index return, which could be positive or negative. Otherwise, the payout will be par plus the greater of the index return and zero.

In the absence of a knock-out event, investors were guaranteed at least par.

Contingent minimum

Under the same conditions - if the index never falls by more than the knock-out buffer amount - some deals last week were even more eye-catching, offering as a minimum the greater of the index return and a minimum contingent return, which in some deals went as high as 10.5% and 20% for the one-and-a-half-year term, according to data compiled by Prospect News.

In this category, the highest minimum contingent return was at 20% through Deutsche Bank's $21.73 million deal of 0% knock-out notes due Nov. 16, 2011 linked to the Dow Jones Euro Stoxx 50 index.

If the index falls below 75% of the initial index level on any day during the life of the notes, the payout at maturity will be par plus the index return, which could be positive or negative. Otherwise, the payout will be par plus the greater of the index return and a contingent minimum return of 20%.

Other offerings

Several other deals priced along the same lines, with or without a minimum contingent return. The higher the minimum contingent return offered, if any, the thinner the knock-out buffer, according to data compiled by Prospect News.

For instance, Deutsche Bank priced another deal for $39.7 million. The knock-out notes tied to Dow Jones Euro Stoxx 50 and due Nov. 16, 2011 had a lower contingent minimum return of 10.5% (instead of 20% with the other offering). But the knock-out buffer was 35% instead of 25%.

Contingent is not guaranteed

A financial adviser looked at the notes paying the 20% minimum contingent return with the 25% buffer.

He said that the product was "risky" given the price decline seen in the European stock market even if the recent stock losses offered attractive valuations for investors seeking to invest in this market.

"They've sweetened the deal by throwing in there this very high contingent minimum return. But you only get that if European stocks never go down by more than 25% anytime in the next 18 months. We know with what's happening now that it can easily go down 25%. That's why they're doing this particular index now."

"The risk is that with this underlying, especially with Europe, there is a great possibility of a decline by more than the knock-out buffer. That can easily happen. And then you end up with an investment that does nothing for 18 months. Eighteen months is a long-time," he added.

"I would like to have an opportunity to get out of the note. These are large offerings, and the issuer may want to maintain a good relationship with you, hence offer you a decent spread. Still, you may not get a very high price on the secondary market," this adviser said.

He added that "the biggest risk is the credit as the bank still has to be there at maturity."

Buying Europe

However, this adviser said that the notes may be attractive for an investor who would be familiar with the underlying index and willing to be long European stocks.

A bet on European stocks, rather than a bet on the hope that the knock-out event will not occur should be the rationale of the investor, this adviser said.

"If you already have exposure to European stocks or if you want to add to a current position, it may make sense, depending on your level of risk tolerance. It's less risky than a direct investment in the index, but it's still risky. However, if you know the underlying and if you want to buy at those levels, then it may work for you," he said.

"But buying it just in the hope of collecting the high minimum coupon is not the right approach. There's too much uncertainty."

Double-hedged sword

An option expert said that the contingent minimum return was the attractive piece of the deal for investors.

But he said that investors may consider hedging the risk; however, he noted that the hedge may not be practical or cost-efficient for investors.

"The investor is long the index. The bank is short the index. The risk for the bank is on the upside. They have to hedge that contingent coupon. For the investor, the risk is to hit the knock-out level. Once that happens, the investor has a problem," said Larry McMillan, president of McMillan Analysis Corp. "For the investor, the index part is irrelevant. The coupon is what makes it worthwhile."

McMillan said that investors would have to hedge the "area" when the knock-out event occurs and the index ends up negative.

"The investor probably has to buy a put to protect himself on the downside. That's the hedge. They probably don't do that as it has a cost," he said.

"The bank sells a put. They almost certainly have to do that. If the index goes down, they have no further risk," he said.

McMillan said that for both parties the hedge was the reverse of the trade.

"The investor is long the index. That's his trade. But his hedge is to be long a put. The bank on the other hand is short this index. It hedges the risk by selling a put to the investor," he said.

Complexity

Al Baker, financial adviser at Pathway Financial, said that he found the product too complex for his investors.

"These are pretty complicated deals. I think this is a product that is too sophisticated for the average person.

There's a niche for some. But it's not for all investors.

Even my best, smartest, most sophisticated clients, those who have money, may be not feel comfortable with this type of investment. They may be more inclined to believe in this product if I recommend it. But if it's recommended by a third party, they'll have a hard time to grasp it," he said.

Credit Suisse too

Credit Suisse AG, Nassau Branch also priced $18 million of 0% index knock-out notes due May 18, 2011 linked to the Dow Jones Euro Stoxx 50 index. JPMorgan Chase Bank, NA was the agent.

The buffer was 35.24%. In the absence of a knock-out event, the payout was par plus the greater of the index return and zero.

Overall $144.86 million of knock-out notes linked to the Dow Jones Euro Stoxx 50 benchmark priced last week in six deals - with Deutsche Bank pricing five of them and Credit Suisse one.

JPMorgan sold all the products for both issuers, according to data compiled by Prospect News.

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