Barclays' barrier dual range accrual notes linked to indexes make for risk-on, income trade

By Emma Trincal

New York, Feb. 11 - Barclays Bank plc's callable barrier dual range accrual notes due Feb. 26, 2024 linked to the Russell 2000 index and the Euro Stoxx 50 index offer an attractive headline rate for investors comfortable with a risk-on approach to the market, sources said.

The hybrid structure, which mixes range accrual and worst-of features, is designed for investors comfortable with taking risk for high-yield returns, they noted.

Each quarter, the notes will pay a coupon equal to the above accrual barrier level rate multiplied by the proportion of days on which each index closes at or above its accrual barrier level, 75% of its initial level, according to a 424B2 filing with the Securities and Exchange Commission.

The above accrual barrier level rate is expected to be 9.2% to 9.8% per year and will be set at pricing.

The payout at maturity will be par unless either index finishes below its knock-in barrier level, 50% of its initial level, in which case investors will be fully exposed to the decline of the lesser performing index.

Beginning Feb. 23, 2015, the notes will be callable at par on any interest payment date.

Tom Balcom, founder of 1650 Wealth Management, said that the odds of getting most of the income a lot of the time are relatively high.

"The likelihood of one of those two indexes to be down 25% ... is very slim. So I think the odds of getting the coupon are pretty high unless you get an unexpected event. And even if you do, look at the last 10 years from 2004 to 2014. You had the year 2008, so you could presume that you would get the coupon only 90% or 80% of the time," Balcom said.

Contingent coupon

Not everyone would want to use the notes.

"This would obviously not be suitable for a conservative investor because of the possible loss of principal if one of the two indexes breaks the strike at maturity," he said.

"Even if there is a low chance for principal erosion, this note is not for the common investor. Instead, I see this product geared towards the high-yield, risk-on type of investor."

Investors get rewarded for taking on that risk, he said. Assuming a 9.2% above accrual barrier level rate, he said that such rate is "way above" the current 2.75% 10-year Treasury yield.

"Your risk is to get paid less or not at all. It is magnified by the fact that both indexes have to be above the 75% level. At the same time, it's a 10-year and they're looking at the initial price, which is much better than a reference point that would change each year or each quarter," he said.

"Nevertheless, investors have to be able to understand the risk. It's a nice coupon, and it makes sense for yield-seeking investors, but there is risk."

High yield

The fact that investors have a return limited to the coupon while the downside risk is tied to the performance of equity markets is not out of the ordinary for high-yield investors, he said.

"The amount of income you get is correlated to the performance of equities. But that's not unusual. High-yield bonds have correlation with equities. Any investor in the high-yield bond is subject to higher risk. This note is no different. You're taking more risk, but you're getting compensated for it," he said.

The call feature, which begins a year after issuance, may not "please" all investors, he said. But a call would only be triggered if the outlook were positive for the noteholder, he said.

"Some investors may be frustrated if the note gets called early. But it may not happen right away, and you do have the one-year protection. You have to look at it on the per-year basis. If you get called, it means that the rate is high, which is good for you. If you get 8% for two consecutive years, it's not such a bad deal," he said.

"I like it. The terms are more complex than the average product, but this is also not a product for the average investor."

Long correlation bet

Michael Iver, chief executive of iVerit Consultancy and a former structurer, agreed that investors have to be risk-takers with a strong bullish bias. One overlooked aspect of the investor's mindset is that buying the notes is the equivalent of being long correlation between the two benchmarks.

"Because you need to have both the Russell 2000 and the Euro Stoxx above the 75% barrier, you want the two indexes to be highly correlated," Iver said.

"When correlation is high, they act as one index, and you would only need one index to be above the barrier. On the other hand, if the two benchmarks are negatively correlated, you have a greater risk of seeing one going in the wrong direction.

"From a risk analysis standpoint, I would call this a capped risk-on trade."

Iver described a risk-on trade as one when investors not only anticipate equity prices going up but also going up at a similar rate.

Capped risk-on trade

"The sentiment is that everything on the global markets is going to go up at the same time," he said.

"Your return is capped at 9.2% since that's your maximum coupon. But the expectation is that the Russell and the Euro Stoxx will move in the same direction, upward, for the maximum number of days so that you can maximize your return.

"Investors in this note are long correlation. They seek to avoid divergence in the direction of the two underlying indexes so that they get only one chance and not two of getting hurt. The risk-on represents the bullish side of being long correlation. You expect everything to move together and in the same upward direction."

Iver also believes that loss of principal is not the most significant risk associated with this product.

"Your principal is at risk at maturity if any of the two indices falls below the 50% barrier. Personally, I think it's hard to think the market would be down by 50% over 10 years, so I wouldn't consider that to be the main risk. The main risk is to get paid nothing or less than the maximum rate simply because your interest accrues on fewer days," he said.

Headline coupon

The issuer is able to offer the 9.2% contingent rate for several reasons, he said.

"This is a 9.2% rate. It's a nice headline number. How do they give you that? First, you're taking the risk of getting zero in order to get 9.2%. For that you're selling 75% daily observation barriers per quarter. In order to give you that type of coupon, they had to sell long-dated barriers, which is the reason why they extended the deal to 10 years. The 50% trigger over three years wouldn't give you much in coupon," he said.

A second factor is the call feature, which typically allows investors to get paid a higher coupon, he noted.

Finally, investors in the notes get paid in excess of the risk-free rate, which is the spread. The question is how much more investors in this product will receive over the yield offered on a 10-year Barclays corporate bond.

5% spread

"Barclays' 10-year notes currently yield anywhere between 3.7% and 4%," he said.

"In comparison, this structured note has a 9.2% potential annualized return. The difference - the spread over a Barclays corporate bond - is between 5.2% and 5.5%. Let's say 5.3% to get a round number.

"The fee is 3.25% over the term. Assume it's about 30 basis points a year to reflect the compounding.

"Taking out the annualized fee, investors who hold the notes for 10 years receive 5% above the 10-year equivalent plain-vanilla bond.

"It's part of the investment decision process for investors to ask themselves if that 5% spread offers enough return to compensate them for the risk they're taking.

"Again, I would discount the risk of losing principal over a 10-year period and with such a low barrier. I think the 50% barrier was just something they used to boost up the coupon.

"But investors need to really assess if 5% above a plain-vanilla bond is enough to take on the real risk, which is the coupon contingency. You run the risk of not getting paid or to get paid less than expected due to the range accrual feature."

Barclays is the agent.

The notes will price Feb. 21 and settle Feb. 26.

The Cusip number is 06741T5X1.

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