Barclays' notes linked to 10 commodity indexes offer autocap but with risk of no interest

By Emma Trincal

New York, March 7 - Barclays Bank plc's notes due March 28, 2018 linked to a basket of 10 commodity indexes may offer a bond substitute to some investors, but the tradeoff is complexity and coupon risk, sources said.

The basket includes equal weights of the S&P GSCI Aluminum Index Excess Return, the S&P GSCI Live Cattle Index Excess Return, the S&P GSCI Cocoa Index Excess Return, the S&P GSCI Cotton Index Excess Return, the S&P GSCI Lean Hogs Index Excess Return, the S&P GSCI Precious Metals Index Excess Return, the S&P GSCI Natural Gas Index Excess Return, the S&P GSCI Lead Index Excess Return, the S&P GSCI Nickel Index Excess Return and the S&P GSCI Zinc Index Excess Return, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will pay a coupon each year equal to the greater of (a) the average of the basket indexes' performances on the applicable coupon observation date and (b) zero.

If an index's return is greater than or equal to zero, its performance will be equal to the return cap. Otherwise, an index's performance will be the greater of its return and negative 15%. The return cap is expected to be between 6.5% and 7.5% and will be set at pricing.

Moving parts, risk

"You really need to know what's happening with these 10 different indexes. It's not like looking at just one," said Matt Medeiros, president and chief executive officer of the Institute for Wealth Management.

"Each individual security has its own independent characteristics relative to the return the client is going to receive. As such, there is a lot to track as opposed to using one security, like an ETF, which is much easier to monitor."

"There are a lot of moving parts. You have to go through simulation exercises," said Steve Doucette, financial adviser at Proctor Financial.

But Doucette said that the security would make sense as a fixed-income substitute.

"I don't see this as a commodities play. Really, it's an income play," he said.

"If you use it as a bond substitute, it might not a bad thing.

"On the flipside, you pay a lot for a 100% principal protection. You could end up not getting paid any coupon at all.

"It depends on the number of times you can get the coupon. If you want to get out of bonds, which is a smart thing to do, then it might not be a bad way to get income."

Bond substitute

By "paying a lot," Doucette did not refer to the fees but to the limit placed on the upside by the 6.5% to 7.5% return cap.

Assuming a 7% return cap, investors who would target a 7% annualized return over the period would need to see five consecutive years in which all 10 indexes would not decline, he said.

"That's a five-year note. You're unlikely to get the maximum," he said.

"That's the scary part for one, because commodities could do nothing for two years.

"You need inflation to start again, and I wouldn't expect commodities to jump up just now. A lot of it is tied to what the Fed will end up doing.

"So you might have three years without any coupon and then perhaps the last two years with a 7% per year. That would give you about 3% a year. It's not much, but it might still be better than a bond. I think you have to look at it that way."

The fee is 3%, or 60 basis points a year, according to the prospectus.

"It's not out of control for a one-time note with a lot of moving parts," he said.

"I don't know how much it takes to manage this basket. Theoretically, you don't need to worry about fees if the paper guarantees your return of principal."

Tracking effort

Medeiros said that the payout formula - with the performance of the basket calculated at the individual index level with an autocap for the upside and a 15% floor on the downside - was too complex for both the adviser and the investor.

"Someone would really have to monitor the independent characteristics of these allocations," he said.

"Equal weighting in general has its place, but when you assign return characteristics independently of the overall basket, then it becomes more complicated and it's more of a challenge to monitor.

"It's also more complicated to explain to an investor."

While the notes are designed for income, Medeiros said that he doubted that they would meet the needs of the traditional bond buyer, which are fixed interest and low correlation with equity.

"I couldn't position this as an alternative to an income product because people looking for income want more certainty and they also want diversification from stocks," he said.

"They look for something that is not equity dependent, and I don't think this product can really give you that.

"In theory, commodities move independently from stocks. But the reality is that over the last two years, commodities and equities have been highly correlated, so the whole purpose of getting a negative correlation to equities may no longer be applicable when you consider this asset class."

Finally, Medeiros said that he would have to consider the benefits of an equally weighted basket of 10 different commodity indexes, which may not perform equally well.

"The issue of having to track 10 securities that are market-cap weighted can be a concern," he said.

"Take the equity space for instance with the S&P 500. We saw last year that 90% of the index return came from 10 holdings, and out of the 10, five of them were financial stocks.

"If I want to generate alpha from the S&P, I can buy a sector as my satellite allocation, in this case the financials.

"The same applies to commodities. It might not necessarily be a bad thing to invest in this particular basket, but you're sort of locked in those sectors for five years without being able to reallocate to the best performing sectors."

The payout at maturity will be par plus the final coupon payment, if any.

The notes (Cusip: 06741TPS0) are expected to price on March 25 and settle on March 28.

Barclays is the agent.

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