Deutsche Bank’s notes linked to iShares China Large-Cap, Hang Seng are not for faint of heart

By Emma Trincal

New York, June 20 – Deutsche Bank AG, London Branch’s 0% securities due June 26, 2019 linked to the lesser performing of the iShares China Large-Cap exchange-traded fund and the Hang Seng index offer opportunities for the right investor, but the volatility of the underliers makes the product inadequate for most, said Michael Kalscheur, financial adviser at Castle Wealth Advisors.

If each underlying component finishes at or above its initial level, the payout at maturity will be par plus 120% of the gain of the lesser-performing underlying component, up to a maximum return of 38% to 42%, according to a 424B2 filing with the Securities and Exchange Commission. The exact cap will be set at pricing.

If the lesser-performing underlying component finishes below its initial level but at or above its 60% trigger level, the payout will be par plus the absolute value of the return of the lesser-performing underlying component.

Otherwise, investors will be fully exposed to any losses of the lesser-performing underlying component.

Almost one

Kalscheur first pointed to the attractive aspects of the deal.

“This is an exciting return. You’re capping out at around 12%. Normally, if you can get 12% on a cap, that’s pretty good,” he said.

In addition, the risk associated with the worst-of payout is somewhat attenuated by the high correlation between the two underliers.

The iShares China Large-Cap ETF seeks to replicate the FTSE China 50 index. The tracked index consists of 50 of the largest and most liquid Chinese companies listed on the Stock Exchange of Hong Kong.

The Hang Seng index is a free float adjusted market capitalization weighted index. It is considered to be the benchmark for the performance of the Hong Kong stock market.

Both underliers are based on shares that trade in Hong Kong, he noted. The iShares China Large-Cap ETF is the biggest Chinese ETF.

“Those two are moving in tandem to a significant degree,” he said, observing long-term charts.

“It’s a matter of who is moving up more than the other or down more than the other.

“And there is also a lot of overlap with the top holdings.”

As a result, the high correlation between the two underliers benefits investors, he said.

Worst-of payouts are riskier when the underliers show low or inverse correlation because there is a greater probability that one index or fund may decline while the other increases in value, he explained.

Concentration, volatility

“This is good. It mitigates the risk a little. But it’s not enough,” he said.

He first pointed to the excessive concentration of the iShares China ETF. First, the top five holdings represent 40% of the portfolio, and second, the financial sector alone accounts for 53% of the fund.

“It’s fairly concentrated right there. And then you have the volatility,” he said.

Based on the standard deviation of each underlier, he calculated that the chances of breaching the 60% barrier are about 2%.

“Two percent is not high, but it’s significant. Once you hit the trigger, you’ve already lost more than 40% of your money.

“It’s a good barrier given the probabilities and the fact that you have decent chances to get an absolute return of 30% or 40%.

“But if you’re wrong ... if you lose half of your money or more, this is not a good conversation to have with a client.

“No matter how you look at it, it’s still a complete roll of the dice.

“If you’re up to the risk, it would be a fun one to ride. But not for us.”

Mild bulls

A look at past performance suggested that the high volatility of each underlier caused long-term returns to disappoint.

The ETF for instance has lost 21% in the past five years and has been flat in the past three.

“It’s been all over the map. Performance over the past few years has been either breakeven or negative ... nothing to be excited about,” he said.

That is not to say some investors may not find the notes appealing.

“If you’re lukewarm on China, as long as the market doesn’t implode over the next three years, it might be the right play for you,” he said.

“You definitely don’t want to be a raging bull because you wouldn’t want the cap. Instead, you’re only betting that China is going to be average or below average.”

On paper

In other words, an investor profile would either be mildly bullish on China or someone with a high tolerance for risk.

“Or perhaps both,” he said.

“I wouldn’t be a fan of this ... for me and for my clients.

“There are too many moving pieces.”

Another disadvantage is monitoring clients’ expectations based on underliers that are not as widely watched as the S&P 500 index or the Euro Stoxx 50, for instance.

“Investors don’t watch those Chinese indexes on a day-to-day basis,” he said.

“But they do watch their statements. You could have a good outcome at the end, but in the meantime you’re in for a roller coaster for the next three years. Most investors don’t have the stomach for that.”

Positive downside

Jerrod Dawson, director of investment research at Quest Capital Management, said he is not considering Chinese exposure at this time. But he thought the structure was interesting.

“We’re underweight Chinese equity. They’re going through the necessary growing pains trying to transfer from an exporting country to a consumption-driven economy,” he said.

Fluctuations in the Chinese currency remain uncertain and make it difficult to assess the development of this transition, he added.

The part of the structure he found the most compelling was the downside.

“I don’t mind the way they structured it with the barrier. You get one-to-one absolute return if you don’t drop more than 40%. If you do, you’re not worse off than if you had only been long,” he said.

“It’s still a pretty big window.”

The correlation between the two underliers makes the worst-of structure a little unusual compared to similar notes.

“It offsets a little bit of the risk.”

Risk/reward

In his view, investors should take a hard look at the upside and the risk-adjusted return.

“There are ways to make money on the downside, but they cap the upside. Is that a reasonable trade-off? It depends on your view,” he said.

The fund from its high in April 2015 to its low in February has already lost nearly 45%.

This downtrend could appeal to bulls, he said, except for the cap.

“It really depends on how much you’re willing to give up on the upside,” he said.

Deutsche Bank Securities Inc. is the agent.

The notes will price on Thursday and settle on June 28.

The Cusip number is 25152R3R2.

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