Deutsche Bank’s 6%-7.8% airbag autocallables tied to LinkedIn are at risky end of spectrum

By Emma Trincal

New York, May 8 – Deutsche Bank AG, London Branch’s 6% to 7.8% airbag autocallable yield optimization notes due May 12, 2016 linked to the class A common stock of LinkedIn Corp. present a high level of risk due to the volatility of the underlying stock and the possibly insufficient amount of downside protection, said Tim Vile, structured products analyst at Future Value Consultants.

Interest will be payable monthly. The exact interest rate will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

The notes will be called automatically at par if LinkedIn shares close at or above the initial share price on any quarterly observation date.

The payout at maturity will be par unless the final share price is less than the conversion price, in which case the payout will be a number of LinkedIn shares equal to $1,000 divided by the conversion price. The conversion price will be 85% of the initial share price.

Sharp sell-off

Vile looked at the recent stock price history on the first day of the month, stating that the 15% level of contingent protection could easily be breached.

The stock sold off in the wake of the company’s first-quarter earnings release on April 30 after the close. The next day, the shares sank 19% to $206.86 from $256.40 the day before.

Before the earnings release on April 30, the stock had been up nearly 10% for the year and had surged 60% over the past 12 months.

“They are pricing the deal now after this huge drop in price. The stock is at a very low level. With the 85% barrier, shares would have to fall to $170, a level not seen since last summer,” Vile said.

The stock was trading at $199 a share in the early afternoon on Friday, still below its May 1 post-earnings level.

“For some, the timing may be good in terms of valuations as you can always expect a rebound after that. Others may see some risk of catching a falling knife,” he said.

If the deal had struck two weeks before the May 1 correction, investors would now be well below the barrier level, he observed.

“Someone may be encouraged to buy at this low level now hoping for a turnaround, especially with a final observation,” he said.

“On the other hand, you’re obviously dealing with a very volatile underlying given the huge loss seen last week. It seems reasonable that the barrier could easily be breached a year from now.”

One risk-reducing factor, he said, is the fact that the barrier is observed at maturity, a type of barrier called “European,” rather than monitored on a daily basis (American barrier), which is often the case with reverse convertibles, he noted.

“The 7% coupon brings some additional protection in the form of a buffer-like cushion,” he said.

Vile said he picked the mid-point coupon rate of 6.9% for his research report.

“But none of those two factors can offset the high degree of risk seen in the notes as suggested by the market riskmap, he said.”

Market risk

Future Value Consultants measures the risk, or “riskmap,” by adding two risk components – the market riskmap and the credit riskmap. Each score is established on a scale of zero to 10 with 10 representing the maximum amount of risk.

The notes are rated against “all product types” as well as the “same product type.” In this case, the product type is the reverse convertible structure.

The notes have a 4.73 market riskmap versus an average score of 4.46 for the product type, according to Future Value Consultants’ research report. The average score for all products is 3.25.

“This is a quite risky product. The 7% coupon can help, but it won’t be enough. The high volatility brings up the market risk,” he said.

The volatility of the stock is over 30%.

“Investors should bear in mind that the barrier can be breached overnight,” he said.

“As of now, a week later, the share price has yet to have recovered from the earnings sell-off. It is still 22% lower than its pre-earning level and more than 3% less than the day following the release, which saw the massive correction.

“Investors still have to go through the next few quarters and should be worried about how strong the market reacted to the disappointing earnings.”

On the credit scale, the product, relatively short compared to other structures and coming from a creditworthy issuer, showed a much better risk profile. Its credit riskmap of 0.28 is exactly the same as its peers, according to the report.

The five-year credit default swap spread for Deutsche Bank is 73 basis points versus 78 bps for Citigroup, 85 bps for Morgan Stanley and 89 bps for Goldman Sachs, according to Markit.

The riskmap for the notes is 5.01 versus 4.74 for the average reverse convertible product and 3.75 for the average for all products, according to the report.

The riskmap suffers from the high market risk, he said.

Risk-return

The return score, which measures on a scale of zero to 10 the risk-adjusted return of a product with 10 being optimal, suffers from the elevated risk level, he said.

The return score is 5.43 versus an average of 7.39 for all products and 5.69 for similar products, the report showed.

“It’s lower due to the high risk. Obviously a fixed income is hindering the return score to a certain extent because your upside is limited by the coupon. The result is due to the existence of a cap combined with a lot of risk,” he said.

“Investors in the notes should be willing to take significant risk to receive some fixed income. You are talking about a monthly income of 0.57% per payment.

“This note is not for the bullish investor. Someone who anticipates a very rewarding upside after the recent sell-off would not buy an income product, which by definition caps the upside. A bull would more than likely opt for a leveraged product with a barrier and a higher cap. Someone even more bullish would get rid of the cap and the protection altogether.

“Even an income investor slightly more bullish would want a higher coupon and may prefer the American barrier type to boost the yield.”

Price score

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10. The higher the score, the lower the fees and the greater the value offered to the investor.

At 4.57, the price score is also lower than the 5.25 average for the reverse convertible category. The gap is even worse when compared to the average for all products, which is 6.86.

“It’s an autocall, and if the notes are called, your duration is reduced, which makes the product more expensive since we calculate the fees on an annualized basis. First, it’s a one-year, which is shorter than a three- or five-year note. And second, it could be called as early as August. The short duration increases the cost of the product,” he said.

Overall score

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

It is 5, compared with an average of 5.47 for the same product type and 7.13 for all products.

“The overall score is not very high. Again we have a bit too much risk for the return offered in the form of the coupon. The pricing certainly does not help either,” he said.

“The score could have been improved with a higher coupon or a more defensive barrier in order to improve the risk-adjusted return.”

UBS Financial Services Inc. and Deutsche Bank Securities Inc. are the agents.

The notes are expected to settle on Wednesday.

The Cusip number is 25190H547.

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