Barclays' leveraged notes linked to Russell seen as penalizing investors too much on upside

By Emma Trincal

New York, May 6 - Barclays Bank plc's 0% buffered return optimization securities due Nov. 30, 2015 linked to the Russell 2000 index presented too much upside risk given the strong bull run of the small-cap benchmark, financial advisers said even though they said the tenor and buffer were valuable features.

The payout at maturity will be par of $10 plus double any gain in the index, up to a maximum return of 20% to 25%, according to an FWP filing with the Securities and Exchange Commission. Investors will receive par if the index falls by up to 10% and will lose 1% for each 1% decline beyond 10%.

Carl Kunhardt, wealth adviser at Quest Capital Management, said that he liked the relatively short duration, the buffer and the simplicity of the product. But he wanted more potential appreciation from the Russell 2000 than what the 20% to 25% maximum return would allow and wouldn't use the notes.

In his view, the bull market is far from over. Therefore, accepting a cap of about 8% to 10% a year would be a big penalty for the investor to pay.

Secular bull cycle

"We've been three years into a recovery, but it's an unusual recovery. People say we haven't had any pullbacks in the market, but it's not so. We have seen pullbacks but in one sector or another, not all at once, not broadly. We've had rolling pullbacks, which is why people haven't paid attention," he said.

"I don't believe the recovery has reached its potential yet.

"As long as we're not in a full-fledged recovery, I continue to be very bullish on the market, especially on small-cap stocks, which tend to always lead the recovery cycle ahead of large-cap stocks.

"The Russell continues to significantly outperform the S&P 500, which shows me that we're not at the point where the economy starts to hit a mature stage."

For Kunhardt, the Russell 2000 has plenty of room to grow as long as the recovery remains subdued. The Russell 2000 has outperformed the S&P 500 since the beginning of the stock market rally in March 2009.

It's only when the economy is in full growth mode that the S&P 500 begins to outperform the Russell 2000, he said, adding that he doesn't anticipate the change anytime in the next two years.

"I will go back to my favorite metaphor. Before you start building a new engine for a car, using a company like General Motors, you need to build the starter and in order to build that, you need a small company to put together the flywheel," he said.

"Right now, the economy continues to build and we're far from the point where the large companies begin to outperform. When that happens, then yes, you have the early signs that orders have started to decline at small-company levels, an early sign of a slowdown at large company levels. But we're nowhere near that yet.

"As we continue to build up in a secular bull, the small caps are going to lead the large caps.

"What this muted recovery has done is to keep the pressure cooker low, extending in my opinion the length of the bull market. While many bull markets are short-term, between five to six years, we could be looking at a five-to eight-year bull run.

"If you take the late '50s, the secular bull market lasted all the way to 1972. That was a 14-years secular bull market.

"So I'm optimistic that we're not near the tail-end of this run, at least in the next two-and-a-half years, it's going to continue."

Because they cap the upside, the notes offer little interest to very bullish investors such as him, he said.

"I expect better returns on the Russell 2000 than the 8% to 10% a year. And keep in mind that you're not even getting the dividend, so you're short approximately 3.5% compared to an outright investment in the index. I think you're giving away too much return. I like the buffer, but the buffer is not enough to compensate me for the performance I'm giving up on the upside," he said.

Michael Kalscheur, financial adviser at Castle Wealth Advisors, also agreed the notes offered good features. His main objections were the cap as well but also the fees.

"It's on the Russell, a two-and-a-half-year, point-to-point with two-times the upside up to a cap of 20% to 25% and a 10% buffer. Barclays is definitely good enough. The deal definitely has nice features," Kalscheur said.

"But the fees caught my attention. They did disclose the fees, which I find refreshing. ... Not everybody does that."

The fee is 2.25%, according to the prospectus.

Expensive

"A 2.25% fee may not be that expensive for the brokerage community, but it's still expensive for the institutional community that we cater to," he said.

Kalscheur noted that he recently saw an offering from another firm showing comparable terms but at a cheaper cost.

"I just received my monthly allocation from HSBC. They're very predictable, every month they send you their offerings at the same time. We like that. The consistency helps plan things around. That's how you can do a laddered bond portfolio with bonds for instance. Well, with that consistency you can also do a ladder structured notes portfolio," he said.

He mentioned a note that caught his attention: HSBC USA Inc.'s 0% buffered Accelerated Market Participation Securities (AMPS) due June 2, 2015 linked to the Russell 2000 index, set to price May 28. The two-year note also had two-times leverage on the upside and a 10% buffer on the downside. The cap was between 19% and 23%.

"It's interesting. I just received it. The features between HSBC's AMPS and this one are pretty comparable: same leverage, same underlying and same buffer. The terms are within six months of each other and the caps vary accordingly by a few percentage points."

However, he pointed to the difference in fees: HSBC in its prospectus stated that the sum of the underwriting discounts and referral fees would not exceed 80 basis points, compared to 2.25% for the Barclays deal.

"Anytime you have a differential on price between two very similar deals, either one of the companies makes a lot more money or it enhances the terms much more significantly," he said.

"I can't say that the terms in this deal are that different."

But Kalscheur said that the fee was not his main objection. Rather, he pointed to the limited potential return.

Opportunity cost

"My concern with this product is the cap. Not wanting to be capped out is often a reflection of how bullish you are. Could we have a Russell up 30% over the next two years? Sure we could," Kalscheur said.

"I think the opportunity cost with these notes is substantial. Yes, you have the buffer; it's not huge, but it's decent. But you know you're not going to get much on the upside. It gives you half of both. Doesn't make you feel good either way. It's hard for me to get excited about a capped performance. It's hard to convince clients and answer their typical question: Why should I do this?" he said.

In general, Kalscheur said that he prefers to avoid capped products "unless you can have some sort of agreement with the issuer that they will unwind the notes if the client is maxed out. That would be ideal, and I guess that's when knowing the issuer can make a difference, and we've had positive experiences along those lines. But you never really know if they'll buy it back at par or if you're going to have to take a haircut."

Kalscheur said that whenever he can, he avoids the cap altogether.

"I realize that you have a 10% buffer and that it needs to be paid for. But rather than capping the upside, I'd much rather extend the duration. When you're capped out, you're stuck," he said.

"If the price to avoid the cap was to go from 30 months to 60 months, I would probably be more comfortable with that.

"In my view, it's better to give up time to get the downside protection that I want and have the uncapped return.

"The shortest we had was a three-and-a-half year. And he was not a buffer; it was a barrier," he said.

Investor profile

Those financial advisers were not sure what type of investor would benefit the most from the notes.

"These notes obviously are not designed for aggressively bullish investors," Kunhardt said.

"It would probably be more appropriate for someone who thinks that the Russell has had a very strong five-year run and can't continue at that rate, someone who anticipates a pullback. But if you have that view, it's not even being mildly bullish. It's the view of someone who is mildly bearish. So I'm not sure who would do this," he said.

"Any investor in this note would have to be somewhat bullish," Kalscheur said.

"You've got to believe the market is going to be up. But you can't be a super big bull. I guess you have to be a moderate bull. You have to expect an annual return in the single digits. I don't think it's an impossible position to have. I just think it's just a small percentage of probabilities.

"If you believe that the Russell will average 5% to 8% a year over the next 30 months, that's a pretty narrow window. I think you're better off doing something else.

"At the end of the day, you have to explain the product to a client. I'm not in the business of defending the product. The product has to defend itself. It's not that it's bad or wrong. I just don't think it's the best one out there for me."

UBS Financial Services Inc. is the agent, and UBS Financial Services Inc. is the dealer.

The notes will price on May 28 and settle on May 31.

The Cusip number is 06742C285.

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