Deutsche Bank’s knock-out tied to S&P 500 index: best scenario is the least likely to occur

By Emma Trincal

New York, July 7 – Deutsche Bank AG, London Branch’s 0% knock-out securities due July 12, 2016 linked to the S&P 500 index offer a complex payout that would make the product difficult to explain and sell to clients, buysiders said. In addition, the digital payout and the type of barrier used for the downside protection generate too much risk for a limited upside, two factors that reduce the appeal of the notes, sources said.

Finally, allocating the notes to the correct bucket may prove to be challenging as well.

The notes feature an “American barrier,” or a barrier that can be triggered any day during the term as opposed to the traditional European barrier observed only once and at maturity, they noted.

The American barrier – or knock-out event – will occur if the index closes below the knock-out level – 60% of the initial level – on any day during the life of the notes, according to an FWP filing with the Securities and Exchange Commission.

Three outcomes

The prospectus laid out three payout scenarios based on the occurrence of a knock out and the level of the index at maturity.

In the first scenario – the knock-out event has not occurred: in such case, the payout at maturity will be par plus a digital return of 6.85% to 7.85%.

In the second scenario, the knock-out has occurred but the final index return is zero or positive. In this situation, the payout will be par plus the greater of the index return and the step return, which will be 6.85% and 7.85%.

Finally with the third scenario, a knock-out event has occurred and the index return is negative. This case is the worst scenario as investors will share fully in losses from the initial index level to the final level.

Carl Kunhardt, wealth adviser at Quest Capital Management, said that at first look, he would not use the notes due to their complexity, although it was worth analyzing the structure closely as some features were still attractive.

Complexity

“I wouldn’t use the notes for a simple reason: I look at structured notes every day and I just spent 20 minutes trying to figure out the payout. If I can’t even simply convey what the triggers for the returns are, I don’t think the client is going to be interested,” he said.

The differences between the first and the second scenario were confusing and slightly “odd,” in his view.

“There are some aspects of the payout that don’t make a lot of sense,” he said.

“With scenario one, you never breach the barrier and yet, you end up with a payout that’s less attractive than scenario two. It’s a little weird. If I never breach the barrier I’m not getting a better return. The best payout scenario here is number two when you breach the barrier. If you don’t breach, you get a digital but you don’t get the upside, so it’s the equivalent of being capped.

“I just find it very odd not to get the full upside when you never hit the barrier and to get it when you breach. Seems counterintuitive to me.

“You want scenario two to happen because it’s the best one. You get at least 7% or more if the index is higher and your upside is not capped. This is the scenario that makes the most sense to me. And yet, you only get it if the barrier is breached and the index finishes positive. Needless to say, this is also the most unlikely scenario.” The most desirable outcome is also the least likely.

“If the barrier is not breached, scenario one gives you only the digital return. That’s very nice if the index is down or up by less than 7%. But if it’s not, your return is limited. That’s all you can get – 7% in two years.

“The first scenario is simple: if you never breach you get the digital. This scenario becomes really attractive in a down market because your digital will enable you to outperform the index. The more the index declines the better your relative performance. As long as the S&P doesn’t drop by 40%, a bearish scenario will allow you to outperform the index the best.”

No alternative investment

Kunhardt said he could explain the payout to investors. Rather it is the purpose of the investment, which he said would be hard to convey to clients.

“It’s not a bad note if you can explain it simply.

“If you breach once and the index is negative at maturity, you’re done.

“If you breach once and the index is positive, you get either the digital or the index with no cap, whichever is better.

“If you never breach, you get the digital.

“OK, fine. You can explain the three scenarios. But what does it all mean? Is it a bullish note? Is it an aggressive note? What would you use it for? This is far less clear.”

Kunhardt said he typically allocates his structured notes to its alternative investment bucket pursuing one of the two goals – return enhancement or hedge.

“What type of return enhancement am I getting here? Assume the digital is 7.5%. That’s 3.75% a year. Is that really an enhancement? This would probably mostly fall into the hedge category. If the index is down 25% and I’m making 7.5% at maturity, that’s a hedge. I would consider it as a hedge on the S&P because you would be giving up the upside for the protection,” he said.

Almost a bearish note

But Kunhardt was still not satisfied by the rationale behind the investment.

“Frankly I wouldn’t use it. It’s not enough return enhancement and the hedge is far from perfect. It is almost a bearish note. You’re capping me at 3.75% per year. If the index never breaches for two years, it’s nice to say – I get my digital.

“There are some notes that lead me to say ‘I’ve got to have it.’ Not this one.

“Yes you can explain it to a client, but I still don’t see a good reason to buy it.

“You have to expect a strong decline over the next two years followed by a bounce back; or alternatively, a decline that never breached the 40% threshold. Both cases suggest that you are more bearish than bullish. I don’t really see enough return enhancement to justify taking the risk if my market outlook is bearish,” he said.

Michael Kalscheur, financial adviser at Castle Wealth Advisors, took a simplified approach of the payout structure by “discounting” the second scenario.

Best outcome is unlikely

“You can look at the first and third scenario and set aside the second one because it is unlikely to happen,” he said.

“What are the odds of hitting the barrier, being down 40% and then bouncing back above the initial price at maturity? Very slim. It would require the index to bounce back up by 70%. It’s so unlikely, I’m almost discounting that.

“The main scenario really is either the No. 1: you never breach that barrier and you get the digital or the No. 2: you hit the barrier and lose the downside protection.”

Kalscheur agreed that the upside was not attractive.

“What do you get out of the first scenario? A 7% digital return, or definitely not even 4% per year compounded. I can’t get excited about getting 7% over two years,” he said.

Not fit for bonds

Before even buying a structured note, Kalscheur said he needs to make the asset allocation decision.

“Is it coming from my cash allocation, bonds, equity? I don’t see it as equity because my return is capped at 7% over the next two years.

“It looks like this product could be taken from a fixed income allocation. I don’t know if I can make 4% in my bonds. It may be a more defensive way to generate income since the chances of going down 40% in two years are pretty remote.”

But the nature of the barrier, not its size, gave Kalscheur second thoughts about using the notes within a fixed-income bucket.

“A 40% contingent protection seems attractive. But the American barrier is what I cannot get comfortable with,” he said.

“I would find it very difficult to tell a client: I’ll take you out of Pimco Total Return fund. In two years, will the Pimco fund yield 7%? Probably not. But can I be down 40% with the Pimco fund? Probably not.

“I always think of a digital as a fixed-income allocation. The problem here is that you have bond-like return with a small but realistic equity risk. I can’t get excited about it.”

A dangerous edge

Even bears may find it risky to invest in the notes in order to capitalize on a market downturn.

“If you’re bullish on the market, you would certainly not buy it.

“But if you’re bearish, you wouldn’t buy it either because if it hits that 40% barrier, you have no downside protection.”

“If at any point you hit that 40% threshold you have no protection. The only way out of this risky situation is if the index is up at maturity, which is unlikely over such a short period of time and such a big drop. So this particular payout scenario does not really help you,” he said.

As long as the barrier is never breached, bearish investors may benefit from the structure of the notes but the American barrier remains too high a risk.

“The best scenario is if the market is down say 30% and stays down 30% at maturity. The digital return will give you the biggest bang for your buck. But if it’s down that much, you’re at the mercy of this type of barrier and I can’t get comfortable with it,” he said.

The product would not fit into his firm’s portfolio, Kalscheur said, because Castle Wealth Advisors has adopted a rule not to use barrier type of structured notes but only buffers.

“We won’t do barriers, especially not American barriers,” he said.

“We just don’t know what’s going to happen. We prefer the buffer with its known protection. Can I quantify how much this barrier increases my risk compared to a buffer? No. If I can’t quantify my risk, if I can’t control my risk, I can’t do it.”

Even as a hedge, the use of the notes would be limited.

“Perhaps if I held the view that the market will be slightly down over the next two years, perhaps I could hold the notes as opposed to shorting the market. This could be a safer way to bet against the market than an outright short. Maybe. But that’s not how I would have designed a hedge. This one is too vulnerable to the downside,” he said.

Finally, Kalscheur said that the 2.5% fee on a two-year note was too high.

“It’s brutal, I am sorry to say. Deutsche Bank is a good firm. They’re single-A, their CDS swap spreads are in good shape. I love the firm. I just can’t get comfortable with this particular offering,” he said.

The exact digital return and step return will be set at pricing.

The notes are expected to settle July 10.

The Cusip number is 25152RLY7.

Deutsche Bank Securities Inc. is the agent.

© 2015 Prospect News.
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