Deutsche Bank's leveraged buffered notes linked to S&P 500 index show inadequate cap for bulls

By Emma Trincal

New York, Sept. 16 - Deutsche Bank AG, London Branch's three separate 0% leveraged buffered notes linked to an equity index or fund offer caps that sources said are too low, either because they penalize bulls too much or because they are too low relative to the downside protection offered.

All three upcoming notes mature between 14 and 17 months after pricing. They all have a 10% buffer on the downside with a 1.111% buffer rate for each 1% of underlying decline beyond 10%.

The first product is linked to the S&P 500 index. Its payout at maturity will be par plus 1.2 times any gain in the index up to a 12.24% to 14.64% cap, according to a 424B2 filing with the Securities and Exchange Commission.

The second product is linked to the return of the MSCI EAFE index. The leverage factor on the upside is 1.3 times. The cap is 14.43% to 17.03%.

Finally, the third deal is based on the iShares MSCI Emerging Markets exchange-traded fund. The return is leveraged at a 1.4 times multiple. The cap is between 16.10% and 18.90%.

"There are too many moving parts here," said Michael Kalscheur, financial adviser at Castle Wealth Advisors.

"Usually you only have the cap that's in a range. With both the cap and the duration being in a range, it's a little hard to make a determination. Since we're in the business of reducing risk for our clients, we have to evaluate this on the basis of the worst-case scenario. Otherwise, we're defeating the purpose of these investments."

Carl Kunhardt, wealth adviser at Quest Capital Management, made the same assumptions. For each deal, both advisers chose a 17-month term and the lower end of the range for the cap.

Kunhardt said that the terms of the notes are too "limiting" for bulls and bears alike. Part of the problem, he explained, comes from the cap levels, which he said are not attractive except for investors seeking to express a range-bound view of the market.

"Sideways market ... that's about the only scenario I would see the note as attractive. This note only works in a limited market outlook, and that's a market that's going to move sideways in the next 18 months. But if you're either bullish or bearish, forget it," he said.

Limited use

"Let's take the less volatile underlying, the S&P. You have a 10% buffer. You have some leverage, but you're capping it and you're capping it at a pretty low level, so what's the point? I get 1.2 times, but I can't get more than 8.5% per year approximately. If I have a positive outlook on the S&P, I would invest directly in it. Who wants to cap the upside at 8% a year? Besides, 1.2 times is not a lot of leverage, and what they're giving you is capped anyway. The purpose of using leverage is to enhance your return, not to lower it," Kunhardt added.

Kunhardt said that bulls would have a limited interest in the notes.

"Forget the perpetual bears for a moment. At some point they're going to be right, but a broken clock is right twice a day," he said.

"The economists I talk to tell me that there is no danger of inflation on the horizon and that until they stop quantitative easing, rates aren't going to go anywhere.

"Now when they stop QE, we'll be back to normal. The supply-and-demand forces in the market will prevail again. Treasuries will fall, rates will go up. Of course it will be a negative scenario, especially for bonds. Well, this note doesn't help you in that scenario.

"So whether the market goes up or down, I have no use for this 18-month product. Unless my market outlook is not going anywhere, I don't see any place for this in my portfolio.

"Now if you want to use it as a hedge, you could. But you would have to put a substantial amount of this note in your portfolio. Besides, it's a very limited hedge because 10% is not going to do much for you if we enter a bear market, which I don't anticipate, but that would be the purpose of hedging.

"This note has a limited utility in my opinion."

Bears and bulls

Kunhardt considered the two other notes, saying that the market is "quite bullish" right now on the EAFE index, which tracks the performance of developed countries. On the other hand, a growing number of investors have turned bearish on the emerging markets. The EAFE index is up 11.3% for the year while the emerging markets fund has lost 6%.

"The bullish case on developed countries makes sense," he said.

"The U.S. has had a strong run. The developed countries will turn around and become stronger than the U.S. In the short term, the U.S. will continue to lead, but the developed countries will follow, getting a little stronger. If I'm strongly bullish on the EAFE, the cap of the notes will dissuade me. It's about 10% per year. A bull would expect much more than that.

"And when it comes to the bearish outlook on emerging markets, I'm facing the same limitations. I'm bearish. The buffer takes out some of the downside, but not enough to encourage me to invest in the notes.

"I just find the use of these notes quite limited."

Cap over term

The relatively short duration of the notes coupled with the existence of a buffer could explain the lower caps, said Kalscheur. But he added that getting a shorter-term tenor would not have been his priority.

"I understand that when it comes to pricing, it's a matter of trade-off. You're giving up dividends, but you're going to have to give up something else, especially if you're getting some downside protection. And what you have to give up is usually going to be measured in time or cap. It's usually a combination of cap and time," Kalscheur said.

"If you're not willing to give up much time, if you want your duration to be short, you're going to accept a lower cap. The economics make sense for someone who doesn't want a long-term product. But for me personally and my clients, it's the opposite: I don't have a problem extending the maturity if I can get what I'm trying to accomplish. Basically, I'm not willing to lower the cap in order to shorten the term. I don't like caps. I'd much rather go further out, even to five years. I don't have a problem with that."

Kalscheur said that he believes investors could lower risk by going longer in duration. He said it is one of his reasons for preferring a higher cap to a shorter term if he could in exchange obtain better terms on the buffer or upside.

"The shorter the term of the notes, the more volatile the index is likely to be. In a three- to five-year period, highs and lows will tend to round themselves out," he said.

"Over a five-year period, the chances of the S&P being down 35% to 40% are very limited, while it could certainly happen over the course of 12 to 17 months.

"Because of the time period being so short, the buffer is not as appealing, as useful as you would like it to be," he said talking about the notes linked to the S&P 500.

"Sure, if the index is down 30%, I'm losing 22.22%, not 30%. That's better than the index, but still. If you're going to cap the index without getting that much protection on the downside, you might as well buy the index.

"Also keep in mind that it's levered on the upside. Your maximum annualized return is 8.65%. In reality, you hit the cap if the index return is only 7.25% before leverage. That's a pretty low bar historically, and you're only getting a 10% buffer on a short period of time, during which the market could be down significantly.

"If I look at the emerging market deal, at first it looks better. You have a higher multiple of 1.4 for the leverage. The buffer is the same, but your cap at 11% for the period looks more attractive. But when you think about it, emerging markets could be up enormously. It's an asset class that can very easily beat that cap.

"We've had success in the structured notes arena because we've used it to get equity exposure while eliminating some of the downside risk. It's a long-term investment philosophy. These three deals structured just around a few months look to me more like trades than investments. It's just not our philosophy."

The Cusip number is 25152RER0 for the notes linked to the S&P 500, 25152REP4 for the notes linked to the MSCI EAFE and 25152REQ2 for the notes linked to the emerging markets fund.

Deutsche Bank Securities Inc. is the underwriter for all three deals.

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