UBS' notes tied to S&P 500, NYSE US 5 Year Treasury offer relative value play for bulls, bears

By Emma Trincal

New York, Oct. 2 - UBS AG, London Branch's 0% relative performance securities due Oct. 31, 2017 linked to the S&P 500 index and the NYSE US 5 Year Treasury Futures index give investors a way to capture returns from the value of equities relative to Treasuries with the possibility of making money even if both markets fall or rise together, sources said.

The notes are viewed as a combined bullish play on stocks and bearish bet on Treasuries, they noted.

The S&P 500 is the "long index," and the Treasury index is the "short index," according to a 424B3 filing with the Securities and Exchange Commission.

The relative return will be the long index return minus the short index return.

If the long index return is greater than or equal to the short index return, the payout at maturity will be par of $10 plus 145% to 155% of the relative return. The exact participation rate will be set at pricing.

If the long index return is less than the short index return, the payout will be par plus the relative return, which will be negative.

Bullish equities

"You're making a bullish call on equities with an additional Treasury component to it," said Donald McCoy, financial adviser at Planners Financial Services.

"You expect the S&P 500 to be up in the next five years, and you see interest rates rising. You expect Treasuries to revert to the mean."

McCoy said that the notes offer the "potential for a very strong return" given the leverage factor of approximately 1.5 times applied to the relative performance as well as the Treasuries component of the trade.

"The boost you can get from Treasuries underperforming stocks is significant with the leverage," he said.

With the payoff based on the relative performance between the two underlying indexes, the structure, not surprisingly, offers no cap.

"It would make very little sense to have a cap here," he said.

Hedge

The notes offer something other than a pure long exposure to the equity benchmark, he noted.

"This is for an investor who has a pretty bullish outlook on equities but wants to add a Treasury piece to his equity exposure because he believes that interest rates at some point in the next five years will have to go up. The five-year Treasury is not as interest-rate sensitive as it can be on the long end of the curve, but if you're right, if the Treasury market does sell off, you can generate an attractive return," he said.

The notes may also be used as a hedge against a decline in equity prices, he said.

"If the S&P 500 is down 5% and the Treasuries index loses 10%, investors in the notes would earn a 7.5% return," he said. He explained that this number results from the 5% relative performance multiplied by the leverage factor.

"It's one of those things. ... They're making an interesting investment vehicle. Intellectually it makes sense, but good luck explaining that to a client. For most people, if you want equity exposure, you just get equity exposure.

"This product has an interesting Treasuries element. But it's very complex because the correlation between stocks and Treasuries is not necessarily that strong one way or the other. There is not a great guarantee that it would work out," he said.

Rising rates ahead

A sellsider said that the notes are built on a negative correlation between the two indexes, which is not atypical in most investors' minds.

"With this product, you are long the equity market and short Treasuries," this sellsider said.

"It's based on the general expectation that typically there is a slight positive correlation between equities and rates. If the S&P goes up, rates tend to go up as well.

"Over the past five years, Treasuries have gone up a lot. This index [the NYSE US 5 Year Treasury Futures index] has gained 36% in the past five years. The hope is that it will decline. What you're looking for when you buy this note are higher equity prices and higher interest rates."

The recent picture since the 2008 financial crisis and the accommodative monetary policy has been quite different.

"Up to now, holding Treasuries was a winning trade. It's a bet that has paid off a lot. But for how long? Investors in this product anticipate a trend reversal," he said.

Timing the sell-off

While the underlying concept of shorting overbought Treasuries makes sense, this sellsider said that buyers may have difficulty understanding fully what they're getting into because the notes are not just linked to one but to two indexes.

"We haven't seen this type of product a lot. Personally, I think it's hard to make a judgment because it's tough to value the risk. You have to worry about performance and correlations among other things," he said.

"You basically have a long equity exposure and with that, you also have a short exposure to Treasuries.

"But why not just buy the S&P and be long equities? I think the answer is that for some people, there is money to be made on a new trend. The investor is not only bullish on stocks. He anticipates a new market dynamic with people selling out of government bonds. The reasoning is 'I'm not just going to be long the S&P. I'm also going to short Treasuries because I think they have reached their long-term high.' That's the bet."

The notes are expected to price Oct. 26 and settle Oct. 31.

UBS Financial Services Inc. and UBS Investment Bank are the underwriters.

The Cusip number is 90269V603.

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