Geared buffers may improve terms, but concept remains hard to sell, sellsiders say

By Emma Trincal

New York, Feb. 20 – Several agents are prepping leveraged notes that include downside leveraged buffers in an effort to improve pricing, according to data compiled by Prospect News.

The feature may be more in use as issuers strive to enhance upside returns while keeping maturities short and providing buffers, a difficult combination that often requires special tweaks, sellsiders said.

Geared buffers, which accelerate losses beyond the buffer threshold, are not new. But sellsiders said they struggle to “sell” the concept, which is perceived as too risky or too complex by advisers despite the improved economics.

Several deals have recently been announced featuring downside leverage by various agents.

Goldman Sachs Group, Inc. plans to price 24- to 27-month 0% leveraged buffered notes linked to a basket of unequally weighted indexes consisting of the Euro Stoxx 50 index, the FTSE 100 index, the Topix index, the Swiss Market index and the S&P/ASX 200 index. The leverage factor is 1.5 times on the upside. The 10% buffer comes with a 1.111 downside leverage multiple.

UBS AG, London Branch was scheduled to price Friday a short-term note (13 to 16 months) linked to the S&P 500 index with an 11% to 13% cap, 1.3 times upside participation rate and a 10% geared buffer coming with a 1.11 factor.

Additionally, Morgan Stanley plans to price this month 23- to 26-month notes linked to an unequally weighted basket that offers exposure to the euro zone, British, Japanese, Swiss and Canadian equity markets. The upside is enhanced by a factor of 1.3 and limited to a 25.35% to 29.25% maximum return. The 12.5% geared buffer has a 1.1429 downside leverage factor.

Structuring tools

When trying to enhance the upside while protecting the downside, issuers may use and combine a variety of tools.

“Short-term interest rates are pretty low. If you go out further, you pick up more yield. Then there’s more to spend on the downside protection,” a sellsider said.

“On a four or five year out, you get enough implied dividends.

“The longer the term, the more dividends you collect and the cheaper the options on the index you’re using.

“Geared buffers are most of the time a way to get more upside.

“It’s not necessarily used to get a bigger buffer. Mostly, it provides more leverage on the upside. It helps the pricing.”

Buffer multiple

The calculation of the multiple is relatively easy and derives from the buffer amount, he explained.

“The gearing is determined by the maximum the client can lose, which is 100%. If your buffer is 20%, the portion of capital at risk is 80%. You obtain the leverage factor by dividing 100 by 80, which is 1.25,” he said.

Using the same calculation, a 10% geared buffer comes with a 1.11 multiple and a 15% geared buffer comes with a 1.1764 multiple.

In some deals, the combination of a longer tenor and geared buffer enables the structurer to eliminate the upside cap while securing a decent-sized buffer, he said.

An example is Royal Bank of Canada’s upcoming four-year buffered leveraged notes tied to the S&P 500. The upside participation rate is in the 114% to 124% range. There is no cap. On the downside, investors lose 1.25% for each 1% decline in the index beyond 20%.

Commenting on this structure, a buysider said he does not like the idea of accelerated losses beyond 20%.

“The introduction of the geared buffer is there to give you more leverage on the upside. By selling more puts, you have more money to buy calls. If someone doesn’t like it, they may have to give up some of the upside. There is no free lunch,” the sellsider said.

Often, advisers’ reluctance to use those types of buffers has more to do with confusion than risk, sellside sources said.

“Some investors don’t feel comfortable with the notion of losing 25% faster their principal. But you do have the 20% buffer. You only start to see the leveraged losses after that,” the sellsider said.

“The downside gearing is definitely better than a barrier, but you lose faster afterwards.

“I don’t think it’s a bad thing at all, but investors struggle with it. They misunderstand it.”

A structurer agreed. While geared buffers can improve terms, they are “hard to explain,” which is why they are not more widely used.

“I’m not big on downside gearing. Not because it’s not a good thing for the client but because they don’t get it. It’s a little hard to explain unless you go back to its history,” he said.

Gearing the put

The “history” dates back to the time when reverse convertible investors used to take physical delivery of the shares, he said, offering the following example.

“I am an investor with $1,000 in principal. The price of Apple is $100. The note has a buffer of 80%. This is the equivalent of selling an out-of-the-money put with a strike of $80,” he said.

When the current price is above the strike price, the put is known to be “out of the money” in options terms.

“If Apple drops by more than $20, if its price goes below $80, I will have to buy the shares at $80. Let’s say Apple drops 50% to $50. My buffer should give me a loss of only 30%, or the difference between the price and the strike. But I have $1,000. I’m forced to buy at $80. At that price, I can buy 12.5 shares. Now the stock is worth $50, not $80. So how much is my 12.5 share position worth at the current price? It’s worth $625. I went from $1,000 to $625. It’s not a 30% loss. It’s a 37.5% loss.

“The $375 loss is my 30% loss times the 1.25 leverage factor. I have a 20% buffer, but I’m participating in 1.25 leverage beyond that. The 1.25 factor is the gearing on the put.”

The structurer said that the conversation with a client becomes difficult when the adviser needs to go through such details.

“That’s the historical explanation. The other reason is pricing. But it’s still a hard sale, because it’s still a little bit too complex to understand.

“For most clients who have a 20% buffer, having to tell them that a 50% price drop is going to accelerate their loss 1.25 times is a bit much,” he said.

Distribution channels

And yet, investors may take advantage of the gearing in several ways.

“First, you get better economics. You could shorten the maturity or enhance the returns. The issuer gets more money to spend on the structure by selling more puts,” he said.

“An additional benefit may be taxes. When you risk 100% of your capital instead of 90% or 80%, it may be easier to get capital gains treatment because the structure is viewed as carrying more risk.”

How geared leverage is embraced depends a lot on the type of distribution channel where the note is marketed.

“If people, some RIAs build their portfolio with this, if investors are used to it, they would probably prefer the geared buffer. It makes sense,” he said.

“If look at this four-year note on the S&P, 1.2 times on the upside, no cap, I would say instead of a 20% geared buffer, you would look at 15% for a standard buffer.

“It’s mostly in the captive distribution networks that you’ll have a better shot at educating the client about the benefits of downside leverage.

“But if you’re talking to new people, the third-party space, it’s more difficult because they’re just not familiar with it and they feel challenged by the concept.

“That’s why I’m not a big fan of geared buffers ... at least from a marketing standpoint.”

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.