Deutsche Bank’s autocallables linked to Euro Stoxx Banks offer high premium on sector bet

By Emma Trincal

New York, June 5 – Deutsche Bank AG, London Branch’s 0% autocallable securities due June 12, 2020 linked to the Euro Stoxx Banks index offer an attractive risk-adjusted return, a financial adviser said. But investors need to be comfortable or at least familiar with the underlying index, which is not often used by U.S. investors.

The notes will be redeemed at par plus a call return of 10.5% per year if the index closes at or above its initial level on either annual observation date, according to a 424B2 filing with the Securities and Exchange Commission.

If the notes are not called and the final index level is greater than or equal to the trigger level, 70% of the initial index level, the payout at maturity will be par plus 31.5%. Otherwise, investors will lose 1% for every 1% that the final index level is less than the initial index level.

“The terms of this deal are very impressive, but anyone buying this has to know the sector. I must say I’m not particularly knowledgeable in European banking,” said Michael Kalscheur, financial adviser at Castle Wealth Advisors.

“That said, I like the structure a lot.”

Yield

He attributed what he called “a very decent 10.5% premium” to the issuer’s use of a high-paying dividend yield.

The Euro Stoxx Banks index yields 3.5%.

“They take this very fat dividend to buy very good terms,” he said, noting that without it, the notes offer a net return of 7% a year.

“That’s still a pretty decent equity premium,” he said.

Memory

The capacity to make up for missed premium is also a plus.

If the notes are not called on the first observation date, investors will receive a 21% premium if a call occurs on the second call date or a 31.5% premium on the third date. Some autocallable products come without this “cumulative” effect, he noted.

“You’ve got three years to make up for any down year. It’s cumulative, so you can catch up the missed premium the next time. That’s pretty attractive,” he said.

“The return that is offered is good, at least it’s good enough to make me want to take the equity risk assuming that I know the index and believe in the sector, which I don’t. I don’t because I’m not familiar with European bank stocks.”

Barrier

Not knowing the sector made it difficult for Kalscheur to assess the soundness of the 70% barrier.

“I can’t tell for sure if it’s enough. It looks like it’s enough based on the chances you have to get the return. But it’s a hard question to answer without knowing more data points about the index,” he said.

One positive effect of the barrier as long as it is not breached is to allow investors to get the maximum return of 31.5% even if the index is down.

“It’s huge! From down 29% to up 31%, that’s a 60% swing. You get a significant potential to outperform the index. Of course, you don’t want to be down 31%.”

One factor of uncertainty common to all autocallable products is the undefined duration of the notes.

“Investors have to accept not knowing how long they will be holding the notes,” he said.

“It’s likely to be called after one year,” he added, based on statistics showing that autocalls are most likely to be triggered on the first observation date.

“But it doesn’t mean it’s a one-year note. You have to treat it as a three-year,” he said.

Concentration

The main issue for Kalscheur was the underlying index.

“It’s a concentrated index. You only have 26 holdings, and the top four are half of the index.”

Those are Banco Santander with a 16.14% weighting, BNP Paribas with a 13.40% weighting, ING Group with a 10.72% weighting and Banco Bilbao Vizcaya Argentaria with an 8.72% weighting, according to a factsheet on the Stoxx Ltd. website.

“If you get the big names right, you’re fine. You just don’t want BNP to go out of business in three years. In fact, if any of those top names goes down, you’re in trouble. There isn’t much diversification in there.”

Kalscheur routinely invests in notes linked to broad-based equity benchmarks, such as the S&P 500 or the Euro Stoxx 50.

Stocks and sector bets, especially in non-U.S. markets, are not his preferred investment style.

Rationale

“You’re buying a sector fund. Just European banks ... it makes me a little nervous,” he said.

On the other hand, the autocallable structure enables investors to maximize their return even in a sluggish market, as long as the index is flat or rises on any call date.

“If it’s positive, you get 10.5% a year and you’re out. If it’s not, you just need to lose less than 30% at the end.”

The long-term performance of the index has not been very strong, he noted, pointing to a 28% decline in the index price since 2001, according to the Stoxx website.

“Someone who likes the financial industry may be looking at it as a value play. If you believe that interest rates are going to rise in Europe, you may have a good reason to buy this index.

“But I would have to do more research on it.

“It’s a very compelling structure. The terms of the deal warrant some additional information if you have clients who are interested in this sector.”

Euro bear

A market participant, bearish on Europe, said he did not like the notes because of the downside exposure.

“It’s as good as the risk you want to take. It’s a creative structure. And if it was on the S&P or the Dow, I’d like it a lot better,” this market participant said.

“European countries have a lot of issues. Their economies are weak. They need structural reforms.”

He said that European banks could be particularly vulnerable in a recession even though some of them are among the largest in the world, operating on a global basis.

“I don’t think a 30% barrier is solid enough for three years,” he said.

“If we have a market correction in the U.S., Europe would take a big hit. We need a new fiscal policy in this country, and we still don’t have it. We’re on very thin ice.

“This is why the options on this deal are pricing up. It’s because of the forward. It’s telling you there is danger down the road.

“Any market crash and Europe could lose a lot more than 30%.”

Deutsche Bank Securities Inc. is the agent.

The notes were scheduled to price June 5.

The Cusip number is 25155MBN0.

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