Investors trade liquidity for growth with UBS' 10-year trigger notes linked to Euro Stoxx 50

By Emma Trincal

New York, July 6 - UBS AG, London Branch's 0% trigger performance securities due July 29, 2022 linked to the Euro Stoxx 50 index are designed for bulls who want to outperform the index over the long run, said structured products analyst Suzi Hampson with Future Value Consultants.

At maturity, investors will get 3.5 to 3.7 times the growth of the index. The exact leverage factor will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 50% and will be fully exposed to losses from the initial level if the index falls by more than 50%.

"A 10-year note is not for everyone. But a long duration in this example can give investors a pretty good alternative to a direct equity investment as they get a leveraged return with no cap on the upside and a deep barrier on the downside. It makes for a good alternative to the index, but you have to have a long-term outlook and no need for liquidity," Hampson said.

"Duration does not reduce risk, however. But in this case, you are getting compensated for the risk you are taking."

Duration, duration

Hampson said that the standard feature of the product is a long duration geared toward growth. The three most appealing aspects of the product are the uncapped return, the high participation rate and the downside barrier.

"When you see a 3.5 to 3.7 times leverage without a cap, it sounds great. It's a very juicy headline rate. Plus you have up to 50% of protection on the downside with a European barrier," she said.

"All of that is great, but the embedded options, the zero coupon you must buy to reimburse 100 if the index falls by 50, these parts of the structure have a cost.

"By making the product longer, the issuer can incorporate all these positive terms."

She calculated the cost of a 10-year zero-coupon bond with a strike at 100 using the 10-year Treasury rate and UBS' 10-year credit default swap spread.

She found the zero-coupon bond price to be 65.33. The discount of about 35 is the amount of money available to purchase the options, she explained.

By comparison, a two-year equivalent product would cost 92, leaving the issuer with only 8 to buy the options.

"There's a huge difference between what you have available to buy on options. The length of time makes a big difference," she said.

"However, if you're used to looking at leveraged products, this one is much longer. Most leveraged products are one or two years in the U.S. So you have to be locked in for a rather long time. That's the trade-off."

High risk

Just because the product features a 50% barrier does not mean it is low risk. Hampson pointed to the high risk profile of the notes compared to other leveraged products using her firm's riskmap, which measures the risk associated with a product on a scale of zero to 10. The higher the riskmap, the higher the risk of the product.

With a 6.32 riskmap, the notes have a much more risky profile than their peers, which have an average riskmap of 4.20. It's also higher than the 4.18 average score for all products recently rated by Future Value Consultants.

"There is a strong correlation between risk and duration with this product," she said.

"It's especially true for the credit risk but also for the market risk."

The riskmap is the sum of two risk components: market risk and credit risk. The 1.45 credit riskmap associated with this product exceeds the 0.98 average of its peers, she noted.

"Credit risk always increases with the tenor, so we have that here. UBS is OK in terms of credit spreads, but the duration has a big effect," she said.

UBS' five-year CDS spreads are 182 basis points, which is tighter than many other banks, she said, citing Morgan Stanley (360 bps), Bank of America Corp. (270 bps) and Citigroup Inc. (250 bps).

The market risk is also above average: the product has a 4.86 market riskmap versus 3.22 for products of the same structure type.

"A lot has to do with time as well," she said.

"Despite the 50% trigger level, you have a bigger chance of breaching the barrier given the long period of time. And if that happens, your chances of big losses are much greater."

In Future Value Consultants' model, equity forward contracts on this index are taken into account to evaluate the probabilities of losses as they give an indication of the future direction of the price.

"If you get a longer period of time and a negative forward, there is more of a chance of breaching the barrier," she said.

Risk versus reward

On the positive side, however, the product shows a very attractive risk/return profile as evidenced by Future Value Consultants' return score, she said.

The rating is calculated using five key market assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

"The best scenario is high growth since you have no cap," she said. Under this scenario, the return score is 9.71, compared with 7.19 for similar products.

"It's a very good return score, in fact one of the highest," she said.

"The fact that it's calculated based on this high-growth scenario and that it's uncapped over such a long period of time ... that can really give you the potential for huge returns."

With its probability chart, Future Value Consultants estimates how the product is expected to perform under the five key assumptions.

When modeling the probabilities based on the optimal scenario (high growth), investors have one chance out of three of getting at maturity more than 15% per annum, according to one of the firm's charts.

However, with the neutral market assumption, which is based on the risk-free rate, the probability of getting the same range of return falls to 6%.

"There's a significant difference between the two assumptions. Our return score is based on the best one. When you combine high growth on 10 years and no cap, you get a very high score. Your chances of generating a strong return are quite high," she said.

Price, overall

Future Value Consultants measures the value investors get from a product with its price score on a scale of zero to 10. The score reflects the value of the underlying components of the product. The higher the score, the lower the fees and the greater the value offered to the investors.

The product scores well above average on this rating with an 8.90 price score versus an average of 7.37 for similar products.

"The score indicates that the issuer has not taken too much fee. It represents the total assets spent on the product, and it's a long product. Since we look at fees on an annualized basis, this high price score doesn't surprise me," she said.

The price score and return score are averaged to obtain the overall score of the product, which represents Future Value Consultants' opinion on the quality of a deal.

At 9.30, this note's overall score exceeds by far the average overall score of leveraged notes, which is 7.28.

"This is a pretty good overall score. It's a product for someone who is bullish long term over European stocks and who doesn't need the liquidity. The potential for high growth, the fact that it can be used as an alternative to this index, all those attributes make the notes quite appealing for long-term investors," she said.

The notes (Cusip: 90268U630) are expected to price July 26 and settle July 31.

UBS Financial Services Inc. and UBS Investment Bank are the agents.

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