Deutsche Bank’s trigger return enhanced notes on EAFE ETF, Stoxx to capture bulls’ attention

By Emma Trincal

New York, April 9 – Deutsche Bank AG, London Branch’s offering of trigger return enhanced securities due May 3, 2023 linked to the lesser performing of the iShares MSCI EAFE exchange-traded fund and the Euro Stoxx 50 index was spotted by a financial adviser as interesting due to the uncapped and highly leveraged upside exposure combined with a deep barrier observed at maturity.

The barrier is 50% of the initial price of the lesser-performing underlying, according to an FWP filing with the Securities and Exchange Commission.

The return on the upside is 350% the lesser-performing underlier’s gain.

Two other advisers who do not usually invest in worst-of structures analyzed the deal with interest as well.

Love/hate

“I don’t like it, but I might do it,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

“I just wouldn’t do a lot of it.”

Before explaining his ambivalent take on the product, Kunhardt said he usually does not buy worst-of notes.

“I just don’t like them. It’s betting against yourself,” he said.

But this deal was different. For one, the notes are growth, not income-oriented, he noted.

Also, both underlying would fit in the same international equity bucket in his portfolio. Both show a fair level of correlation, which reduces the risk of worst-of exposure, he added, pointing to the high European equity weighting (over 60%) in the MSCI EAFE index.

The correlation coefficient between the two underlying is 0.97.

Three little guys

Kunhardt could attribute his liking of the deal to animal spirits.

“3.5 times leverage with no cap. That’s great! I totally understand this is coming from my greed. It’s a little guy on my shoulder dressed in bright red that says: go for it!”

“Hey, but it’s a 50% safety net. That’s also a little guy dressed in a shade of red, my greed again that’s getting really excited.

“But then there’s a little guy dressed in white who whispers in my ear: ‘keep in mind it’s a barrier, not a buffer. And it’s a note you’re buying for five years. You’re in it for five years.

“Now do I want to side with the little guys in red who like it?

“I would say yes, I would if I’m an aggressive investor.”

How would he select the clients that may consider the product as an opportunity?

“You want to stick to people who understand the deal and have a significant risk tolerance,” he said.

Expected returns

The reward of the notes could satisfy more than one kind of bullishness. Very bullish investors would relish the uncapped upside. More modestly bullish clients would appreciate the high participation rate.

Kunhardt is only mildly bullish for the next few years. He follows Mercer’s forecasts, which predicts a 7% annual rate of return for equity.

“That’s about 122% for the five years, almost 25% a year,” he said.

“I can hear the little red guy screaming – do it! – and the other red guy saying: you still have a 50% safety. After all, when you buy a stock, you’re taking the risk of losing 100% of your principal. An aggressive investor would do it all day long.”

If he had to predict which of the two underlying would be the worst-of, Kunhardt would pick the Euro Stoxx 50 index, which is more concentrated than the MSCI EAFE index comprised of 900 components.

“I would do those notes for some more aggressive clients. If I did it for a client I would do it for myself,” he said.

Some advantages

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, said he did not like very much the downside exposure but conceded that the notes offered a few features that would benefit investors.

“I like the fact that the two underlying securities are very similar with a big European component in the EAFE. It’s better than having a worst-of with two or three things that are completely different,” he said.

“I also like the upside with the no cap.”

Leverage vs. dividends

As with most structured notes, investors do not receive the dividends. The two indexes pay fairly high dividends, he noted, and over a five-year period.

“You’re losing that, which is a negative. But you’re also getting significant leverage that makes up for it,” he said.

The less attractive features in the deal were the tenor and the barrier.

“Five years is really a long time. You have to be bullish on these two securities for the next five years, which is certainly possible. But I don’t know that many people who are bullish for five years out. In five years the market could finish up but it could just as well go down.

“You’re in a note that’s not very liquid; you’re in it for five years in a very challenging environment.”

Barrier to barriers

More fundamentally, Chisholm said that he was not comfortable with the barrier.

“A 50% barrier is quite large. It’s a lot. I’m not really worried that it would breach because it’s unlikely. And yet, once you do, you’re pretty much on the hook. Then you have to explain to a client that their return is linked to the worst-of.”

Part of the barrier “problem” was related to Chisholm’s dislike of worst-of payouts.

“Anytime you throw a worst-of in there it’s not an ideal situation. I can’t really explain that to a client. From a marketing’s standpoint it has no appeal,” he said.

Investors’ tastes vary

A solution would be to replace the barrier by a buffer.

“I know you couldn’t get 50% with a buffer. It would be much less, but I still prefer to know that a portion of my principal is protected.”

A market participant said some investors will always prefer buffers regardless of the barrier size.

“Some advisers prefer that hard protection. You’re always protected. If you lose, your losses get cut. You always outperform the market,” he said.

An equivalent deal with a buffer would probably allow for 20% to 25% of hard protection, he noted.

Investors in the barrier camp would pay more attention to the size of the barrier than to its contingency.

“Others would say that the probability of a decline of more than 50% over five years is so unlikely, I’ll take that probability risk.

“But it’s certainly not for the most conservative investor,” he said, pointing to the amount of losses that would occur in this scenario: half of the initial investment at least and possibly all of it.

Funding levels

A longer timeframe does not reduce the risk of breaching a barrier, he said. But it helps enhance the upside.

“Selling a 50% put over five years is worth more than doing it over two years, so your upside looks better than if you did it over two years,” he said.

This is probably how the structure could be put together without a cap and such a high leverage multiple, he reasoned.

Funding rates helped too.

“It’s a debt instrument. You get the funding component. You get more funding over five years than over two,” he said.

Additionally, the credit default swap spreads of Deutsche Bank have recently widened to 117 basis points for the five-year from 90 bps in mid-March, according to Markit.

However, this is true across the board as U.S. banks have also seen their CDS spreads widen during the same time.

“You’d be looking at this note if you wanted long-term exposure to international stocks with no cap and if you were willing to tie up your money for five years,” he said.

Investors seeking a shorter alternative would not get the same benefits.

“I’m guessing you might have to settle for a 70% barrier and between 1.50 and 1.70 leverage.

“It wouldn’t quite be the same,” he said.

Deutsche Bank Securities Inc. is the agent.

The notes will price on April 30 and settle on May 5.

The Cusip number is 25155MKQ3.

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