Market mixed about absolute return barrier notes: knock out offsets capital protection, analyst, advisor say

By Kenneth Lim

Boston, July 3 - Absolute return barrier notes are a mixed bag with as much to like as dislike, said investors and analysts.

The structure, which has been used in a number of products recently, offers a positive return as long as the underlying trades within a certain range.

Structure gains presence

Recent issuers who have used the structure over the past week include Credit Suisse, Deutsche Bank AG, JPMorgan Chase Bank and Royal Bank of Canada.

UBS AG also plans to price a series of zero-coupon principal protected notes due July 29, 2009 linked to the S&P 500 index.

At maturity, each UBS note will pay par of $10 plus the absolute index return as long as the underlying index never closes outside of a certain range during the life of the notes. The upper index barrier will be between 119.75% and 122% of the initial index level and the lower index barrier will be 90% of the initial level. The exact barrier levels will be set at pricing.

If the underlying index closes outside of the range during the life of the notes, investors will receive par.

Volatility key to structure

Structured products research firm Future Value Consultants rated the UBS note with a below-average level of risk, but its value rating was also poorer than other recent products, said analyst Suzi Hampson.

The principal-protected absolute return barrier structure can be a gamble for investors because the product will only seem attractive if the underlying volatility falls within a certain range, Hampson said.

"Due to the way that they're structured, if the underlying is not volatile at all, you're going to get something close to your principal," she said. "If the underlying is more volatile, which you need if you want good returns, there's much more of a chance of it breaking the barrier, but your risk goes up. It tends to score not very well on our return rating because you need more volatility, in which case it's too risky, or it's not volatile enough for you to get your return."

"You want movement, but not too much," she said, summarizing the quandary for investors.

The structure could work for investors who do not have a strong view of the market's direction, she added.

"I guess it would appeal to somebody who didn't have a view of where the underlying was going," she said, noting that the principal protection is the key attraction in the structure.

Structure a mixed bag

Blue Bell Private Wealth Management managing partner Scott Miller Jr. described the structure as having "some positive and negative to it."

"You are in a lot of ways getting principal protection and ... in terms of tax treatment it still qualifies for capital gains, so that's a positive. And I think you understand that in a market that isn't very volatile, you'd be able to make money in that market also."

But the knock-out aspect of the notes, where the gains are erased once the underlying crosses the barrier levels, tempers the appeal of the structure, Miller said. Because the barrier can be crossed at any time during the life of the notes, the value of the product is always affected by that risk, he explained.

"Because of the knock-out feature, if you're going to have to sell early they're always going to be around par," Miller said. "Even the firms, when they buy these up, I can't imagine that they'll give you much more than par."

Blue Bell currently only uses the structure in some portfolios, but in most cases the firm uses other structures, Miller said.

"These as part of a diversified portfolio may work," Miller said. "If you have a portfolio that's very aggressive and you're going to make a lot of money if it goes above the barrier, then this product might make sense."

Blue Bell investment advisor representative Jon Sobotkin added that products with the structure could be seen as a cash substitute.

"Some people like this as a cash substitute strategy," he said. "They don't want to be holding cash but they don't really want to be in the market...if it breaks the barrier on the downside they get back their principal. They're fine with accepting their principal back."

"Sometimes if you go out there and buy a CD, you find that you're getting such a low rate...you're willing to take on a bit more risk rather than take such a low rate. If the barrier is broken, you find that you're not losing a whole lot of interest."

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