Harris CDs on Dow Jones Select Dividend ETF offer high call premium, straightforward structure

By Emma Trincal

New York, Aug. 4 - Harris NA's upcoming principal-protected certificates of deposit due Aug. 31, 2016 linked to the iShares Dow Jones Select Dividend index fund offer a simple, easy-to-understand structure with an appealing call premium, a market participant said.

The payout at maturity will be par plus the index fund return, which is subject to a cap of 34.05% and a floor of 0%, according to a term sheet.

The CDs are callable at any time beginning March 1, 2011. If called, the CDs will pay a 5% annualized call premium.

Two options

"It's really simple. It's a six-year CD callable after six months. If it's called, your return is based on a call premium of 5%. If it's not, your return will be the greater of zero and the index [fund] return," the market participant said.

The maximum return of 34.05% is simply based on the 5% annualized call premium over the term of the CDs plus compounding, he explained.

"The issuer is not going to pay more than the call premium," he said.

Attractive call

"People who buy into the CDs are hoping to get called," this market participant noted.

"They want to outperform a traditional CD. Right now you're only getting something like 2.7% on a six-year CD," he said.

If the product gets called, it offers a great alternative to a plain-vanilla CD, he said.

However, the call is not automatic and occurs at the issuer's option, he noted. As a result, investors should be ready for the second payout alternative, which is par plus the exchange-traded fund's return.

In the term sheet, the issuer warned about some of the risks involved with this scenario: "In some cases, no interest will be earned on the CDs based on the performance of the ETF."

Call factors

"Many factors could trigger a call. It depends on interest rates. It depends on how the ETF is doing. A lot could happen," the market participant said.

"The call sounds like a better alternative, but the CDs will be called if it's in the issuer's interest to do so," said Tony Romero, co-founder and managing partner of Suncoast Capital Group. "It's hard to say under what circumstances the CDs would get called," he added.

Noting that the ETF is now trading at $46, Romero said that one likely call trigger would be a sharp appreciation in the value of the underlying.

"I guess if the price behaved like it's going to be trading $80 in six years, at that point, they would call it, just to save themselves some money even though it's capped," Romero said.

Forgoing yield

Romero said that while a call would be attractive, the scenario in which the issuer decides not to call the CDs raises some concerns.

If the notes are not called, investors would see their return tied to the ETF performance. But as it is the case with equity-linked products, investors would have to forgo the dividend payments offered by the ETF. In doing so, investors may be losing an important source of added value, Romero argued, simply because the underlying ETF offers attractive dividends.

The iShares Dow Jones Select Dividend index fund tracks the performance of the Dow Jones U.S. Select Dividend index. This index measures the performance of 100 of the highest dividend-yielding securities, with the exception of real estate investment trusts, in the Dow Jones U.S. index.

Romero noted that the 100 companies comprising the index were selected for their high dividend yields but also for their capacity to offer sustainable dividend payments. The ETF's dividend yield is currently 3.89%.

"If you hold the ETF and do nothing, you almost get 4% in yield without even considering any movement in the price," Romero said.

While the current 3.89% yield is going to vary over the life of the CDs and could be lower, Romero said, "I don't see it fluctuating by much" because "stocks in the Dow are established and have consistent dividend yields."

Because the "purpose" of the index is to "specifically select stocks that offer consistent dividend yields," Romero assumed that "it's very likely that this yield would remain consistent."

Even if the ETF appreciated substantially at maturity, investors in the CDs would end up giving up a significant source of returns as they forgo dividend yields, he said.

Ultimately, risk-adverse investors may opt for the CDs for the peace of mind and the capital protection, he noted. "But they may be paying a high price for it."

"If you had a similar CD based on an ETF with not such a high yield, then it may work. But here, you're sacrificing the dividends for that floor. That's the trade," he said.

The CDs (Cusip: 41456TJE0) will price Aug. 26 and settle Aug. 31. Incapital LLC is the distributor.

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