Deutsche Bank’s buffered notes linked to iShares MSCI EM ETF seen as lacking sufficient upside

By Emma Trincal

New York, June 17 – Deutsche Bank AG, London Branch’s 0% buffered notes linked to the iShares MSCI Emerging Markets exchange-traded fund, despite a short tenor and a 10% buffer, do not offer enough return potential to make the risk-reward trade-off attractive, buysiders said.

The notes are expected to mature 22 to 25 months after pricing, according to a 424B2 filing with the Securities and Exchange Commission.

If the fund return is at least negative 10%, the payout at maturity will be par plus the digital payment of 9.25% to 12.25%. Investors will lose 1.1111% for every 1% that the fund declines beyond the 10% buffer.

Recent rise

Dean Zayed, chief executive of Brookstone Capital Management, said that he likes the underlying asset class but not the risk-reward profile.

“Emerging markets have clearly lagged the domestic equity market in the last couple of years. They have perked up recently. It’s an interesting underlying,” he said.

The ETF is up less than 4% this year to date. But Zayed pointed to the price increase of 17% since Feb. 1.

“We’re seeing a move as we’re getting close to the 52-week high,” he said.

The ETF closed at $43.42 on Tuesday. Its 52-week high is $43.98.

“The index has clearly underperformed, and now it’s gone back up, which could be good or bad. It could mean that it’s breaking out of a slow couple of years, or it could be that the big uptrend move has already taken place given that we’re already so close to the 52-week high,” he said.

Mild view

Zayed said the security is not a good choice for very bullish investors.

“This note is trying to capture a moderately bearish or moderately bullish view. But the digital rate is not competitive enough for the risk you’re taking,” he said.

“I like the underlying, the terms, the structure. But the return is not commensurate with the risk you’re taking given the issues emerging markets have had even recently.”

Rather than using a note, Zayed said he would get exposure to emerging markets only through actively managed strategies.

“The index gives you a broad-brush exposure. The fund allocates heavily to China, and we’re cautious about this market,” he said.

“We think active managers with a team of experts are the way to go when you invest in emerging markets.”

Volatile

For Steven Foldes, president and chief executive of Foldes Financial Management LLC, the digital payment, which caps the upside, is too low.

“The emerging markets is a very volatile asset class. The standard deviation of this asset class is wider than that of the U.S. or even of the developed markets,” Foldes said.

“We recognize the volatile aspect of this investment, and we tell our clients that there is a potential for a lot of returns.

“We have a small allocation to it because I would hate to be out of emerging markets once it explodes.”

Foldes said the capped upside is the price to pay for the 10% buffer on the downside, but he added that the trade-off is not worthwhile.

“A 10% buffer with emerging markets is really not a lot,” he said.

“The idea of being capped at about 10% for two years for a 10% buffer is really not that appealing when you look at the performance of this fund.

“You should be able to get a handsome return from this asset class. We project higher returns in emerging markets than in the U.S.”

Undervalued

He backed his projection with the fact that emerging markets have shown a disappointing performance since the beginning of 2011, which may indicate a potential reversion to the mean.

“Last year was negative, and this year has not been huge so far, especially in the beginning of the year,” he said.

“It was negative 19% in 2011, then up 19% in 2012.

“The asset class since 2011 has had a low valuation relative to the U.S. The fund is cheap as it relates to equities around the world.

“Of course, it got clobbered in 2008 with a negative return of 49%. But it was up 69% the following year.

“This is not an asset class for the timid.

“The index has shown spectacular years. From 2004 to 2007, during those four years the weakest year was 2004 with 24.64%. In 2005, 2006 and 2007, the poorest year was 2006 with 31.41%.

“So you had years of huge gains preceding 2009-2009 and a lackluster performance over the past two and a half years. If anything, the expectation is that we’ll soon see a reversion to the mean.

“We certainly want to participate to the returns with our clients. We wouldn’t want to be doing away with the upside.”

Buffer too small

Because the fund may decline significantly in stressed years, Foldes said the 10% buffer is of little help.

“Ten percent is relatively meaningless for that type of volatility. It certainly doesn’t warrant sacrificing most of the returns that we expect,” he said.

“If your index is down 50% like in 2008, you’d lose 44.5% instead of 50%. That’s not a big deal.

“I don’t really see a positive risk-reward with this trade.

“I understand that banks are struggling because interest rates and volatility are very low. It’s certainly not a great environment for structuring notes. But this is not for us.”

Deutsche Bank Securities Inc. is the agent.

The Cusip number is 25152RKY8.

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