Deutsche Bank’s notes tied to sectors offer diversified bet, but cap, risk seen as unfavorable

By Emma Trincal

New York, Aug. 13 – Deutsche Bank AG, London Branch’s 0% capped knock-out notes due Feb. 23, 2017 linked to a basket of indexes give investors the convenience of being able to bet on four different sectors of the U.S. stock market in one instrument, but some of the terms are an issue when it comes to the risk-reward profile of the product, financial advisers said.

The equally weighted basket includes the Financial Select Sector index, the Technology Select Sector index, the Consumer Discretionary Select Sector index and the Health Care Select Sector index, according to an FWP filing with the Securities and Exchange Commission.

At maturity, investors will get par plus the basket return up to a maximum return expected to be at least 15%.

If the final basket level is less than the initial basket level but at or above the knock-out level, which is 82% of the initial level, the payout will be par. If the final price is below the knock-out level, investors will be fully exposed to the basket’s decline.

For each index, the final level will be the average of its closing levels on the five trading days ending Feb. 17, 2017.

Barrier

Steve Doucette, financial adviser at Proctor Financial, said the downside protection could be improved given the volatility of most of the underlying sector indexes.

“If you get this note, you think the basket of underlyings is going to be within a reasonable range,” he said.

“Fifteen percent over 18 months is 10% a year. It’s not bad.

“You get 18% protection on the downside. But it’s a barrier. I’d like to see a buffer here instead because if the market turns ugly, you don’t have protection on the downside. You’re long the underlying.”

Volatile sectors

The need for better protection was the result of the choice of the different sectors making the basket, he said.

“They put an interesting mix of sectors. Tech did very well. Financials and tech are volatile. The underlying health-care index is quite volatile too because you have a bunch of biotech in there,” he said.

Biotechnology stocks represent almost 21% of the Health Care Select Sector index. Some biotech stocks known for their high volatility levels are among the top 10 holdings such as Gilead Sciences, Inc., Amgen, Inc. and AbbVie, Inc.

Financial and consumer discretionary stocks were also seen as risky.

“Financials would be doing poorly in a bear market. The benefit for the sector of a rate hike has already been factored in,” he said.

“Consumer discretionary could be the most defensive, although this is far from being a stable sector. That’s the big ticket item, the car, the washing machine ... all things that if we have a pullback will go down harder than staples.”

Buffer needed

Because the 82% barrier could be easily breached if the market were to turn bearish due to the exposure to four volatile sectors, Doucette said the barrier is not sufficient as a protective feature.

“The terms should be modified,” he said.

“I would look toward getting a buffer. That would be the only way I could consider this.

“You’re long in either direction; you’re capped in it, no leverage and unlimited downside.

“I would probably look for outperformance on the downside, which you do get with a buffer. With a barrier you get it too up to a point. Once the barrier is breached, you have zero protection.

“If you’re long the index, you don’t want to be capped too much. I could probably live with the 10% annual cap and try to replace the 18% barrier with a 10% buffer, just as an example.”

Bullish

Matt Medeiros, president and chief executive at the Institute for Wealth Management, who holds a bullish view on the basket, was more concerned with the cap than with the barrier.

“I’m familiar with the Select Sectors. I like the four sectors that they picked for this note. These sectors offer potential for growth. I would be bullish on this particular basket,” he said.

He explained why he was bullish on the financial sector.

“Financial institutions have certainly struggled in the low rate environment, and with potential rate increases hopefully we’ll see some margin improvements for the banks. That margin improvement will more than offset the potential slowdown in mortgage applications,” he said.

“I’m also positive about consumer discretionary. Household saving rates have continued to improve, so that’s good. Hopefully if consumers continue to feel a little bit more confident in the economy perhaps they will begin to spend a little bit more.

“I’m also bullish on health-care stocks. If I look at this basket, I like them all.”

Another type of basket with sectors he favors less would have not made the cap such an obstacle for him, he said.

No cap

“If they had put in there sectors like energy or interest-rate sensitive sectors, like utilities for instance, it would have been a different story. I would be able to factor that into my willingness to take the cap. But with this basket in the note, I don’t want the cap.”

As a result, Medeiros said that he was “not particularly fond of” the structure.

“I’m bullish on this basket. I don’t want to be capped at the end of 18 months,” he said.

“I realize the trade-off for this cap is the downside protection, but I don’t like the barrier approach. I would prefer a buffer.”

Not having leverage on the upside was not his main concern.

“To me it’s not about the delta one. It’s about participation. I want to get the full upside,” he said.

“If I’m going to take equity risk, I want to have equity rewards.

“Having 100% of my money at risk and getting only 15% of the upside is not what I would consider equity reward.”

JPMorgan Chase Bank, NA and J.P. Morgan Securities LLC are the agents.

The notes will price on Friday and settle Wednesday.

The Cusip number is 25152RM42.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.