Barclays’ $2 million contingent coupon notes tied to three indexes show high odds of payment

By Emma Trincal

New York, Jan. 29 – Barclays Bank plc’s $2 million of callable contingent payment notes due Jan. 30, 2025 linked to the least performing of the S&P 500 index, Russell 2000 index and Euro Stoxx 50 index give investors a high probability of getting paid a coupon and suggest a lower risk of losing principal at the end, according to a financial adviser.

The possibility of losing a large amount of money remains, however, which explains the attractive contingent coupon of 10.25% per annum.

The notes will pay the quarterly contingent coupon of 2.5625% on any quarterly evaluation date when each underlying index closes at or above its coupon barrier level, 70% of the initial level. Otherwise, no coupon will be paid that quarter, according to a 424B2 filing with the Securities and Exchange Commission.

The notes are callable at par plus the contingent coupon on any interest payment date.

A low barrier of 50% protects the principal at maturity. Investors will receive par unless the least-performing index finishes below the 50% barrier level, in which case investors will be fully exposed to the decline of the least-performing index.

The odds are good

“These notes are really interesting,” said Steve Doucette, financial adviser at Proctor Financial.

“It seems like the only way you underperform is if you’re stuck between 50% and 70% so you can’t collect the coupon. In that situation, you can’t sell it because you would be losing a lot. You’re locked in.

“But when I look at the probability of collecting a coupon, even with the worst of, the odds are pretty good unless one index is below 70%, [in which case] you don’t get paid for that quarter. But you can have a few quarters with a correction and then the market comes back and you collect again. I just don’t like the 10-year term.”

Call option

The fact that the notes were callable on any quarterly observation date at the discretion of the issuer and not automatically callable was seen as common with those types of long-term notes.

“They’re all set up this way,” he said.

“If the market goes through a severe correction, down 40% or 50%, obviously they won’t call it then. They would have to repay your principal. They never call in that type of scenario. It’s only if the market is up that they will call it. But until then, you still get paid unless one of the markets falls by 30%.

“I like those notes. But they always look too good to be true.

“If it’s down, you can’t really sell it. You’ve got to hold it. You’re really long the index. But again the market could go down and back up. Or it may be down but you’re still earning something. Say the market is down 10%. You collect a 10% coupon. Not bad. All you need to do is hold the notes until the market rebounds.”

Final barrier

The odds of losing principal were also favorable to investors, according to Doucette.

“Assuming they don’t call the notes, your barrier at maturity, especially after 10 years, is pretty good,” he said.

“Unless one of the three indexes loses half of its value, you’ll get your money back.”

Even during the financial crisis, none of the three underlying indexes lost 50%, he noted.

During the severe bear market of 2008, the S&P 500 lost 37%, the Russell 2000 dropped 29%, and the Euro Stoxx 50 was down 45%.

“It amazes me how they can structure these kinds of deals. What kinds of derivatives are they using? The odds of getting your coupon are pretty strong. The odds of losing principal are pretty slim. In 2008 only emerging markets dropped that much. To me, this note looks like something that pays a decent return with a low probability of loss.”

Contingent income

Doucette said his firm has been using income products with contingent coupons since 2008 as a fixed-income alternative as a way to hedge against interest rate risk.

Rather than this product that gives a coupon independently from an early redemption scenario, his preference is for the traditional autocallable notes that pay a call premium when the notes are called. That’s because the call payment represent a capital gain from a taxation standpoint while contingent coupons get treated as ordinary income.

“Other than that, when I look at the risk return, I really like this note,” he said.

“It’s just a question of how long you want to hold it.”

Risk versus reward

A market participant agreed that the odds worked in the favor of the investor in relation to the chances of getting the coupon and not losing principal. Yet the risk was substantial too as measured by the potential amount of losses, the worst-of payout and the long duration of the notes.

“This note is definitely interesting. First, it’s unusually long. But you get 10.25%, a fairly high coupon. In addition, it’s one thing to get 10% from a weak underlying or a stock, but you’re getting this coupon with a quality underlying – we’re talking three broad-based indexes.

“The 70% barrier is decent. Most likely, you’re going to get those coupons for a while. The market can always go down by 30%. That can happen. But you have the 50% barrier at maturity. Most people are comfortable with that.

“So what are the risks?

“First, you could end up not getting your coupon along the way.

“The Euro Stoxx could crash soon like Japan in the ’90s. Japan is an example of a market that has fallen by 50% or more. Can it happen? Yes. Will it happen? It’s not likely, but it’s still a risk.

“You’re taking some risk, so you’re getting compensated for that with a nice coupon. Things hopefully will turn out to be good, but it’s a risk.”

Risk premium

This market participant explained how the issuer was able to build a product that offers attractive probabilities in terms of risk and return.

“You’re taking risks, and you’re getting paid for that. But this structure wouldn’t be doable if you didn’t have a number of things that work in the issuer’s favor,” he said.

The first one was the option to call the notes.

“It’s a waiting game for three months. They don’t have to keep paying the coupon. If the market goes up, they call it. It doesn’t cost them a lot. They can call it at any time. They have the option to do that,” he said.

“If on the other hand the market is down, they won’t call it because the chances for the investor to lose the coupon or lose some principal will increase. If the market goes down, the issuer stays in the game. If it crashes, it’s the best outcome.

“So while it’s true that the odds of getting paid are high for investors, it’s not just the odds that count. If investors lose, they will lose a lot of money. And if they win, they’re not going to make a killing. You can’t just look at the probabilities. You have to multiply the odds of losing by the amount of losses.”

The worst-of payout was another aspect of the structure that enabled the issuer to offer such a high premium.

“Your return, your payout is not linked to one index but to the worst of the three. And you have three indexes.

“Looking at one index is one thing. Looking at the worst of three multiplies the odds of a negative event.

“It only takes one of the three to lose principal at maturity. But you need all three to be above the 70% barrier to get paid.

“So you are taking some risks, and you’re compensated for it. This is not much different from a reverse convertible, except that it’s a 10-year and that you’re subject to the issuer’s credit risk [for longer].”

The notes (Cusip: 06741UPG3) priced Jan. 26.

Barclays is the agent.

The fee is 3.9875%.

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