Barclays' return enhanced commodity-linked notes add risk with basket, downside leverage

By Emma Trincal

New York, Nov. 17 - Barclays Bank plc's 0% buffered return enhanced notes due Nov. 21, 2013 linked to a commodity basket are risky because of the concentration of the underlying basket and the downside leverage, according to two financial advisers.

Investors will have to evaluate those two elements of the structure in order to decide if the risk-reward profile matches their expectations, they said.

The basket includes equal weights of Brent crude oil, platinum, copper and the S&P GSCI Grains Index Excess Return, according an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 185% of any basket gain, up to a maximum return of 27.75%. Investors will receive par if the basket declines by up to 20% and will lose 1.25% for every 1% that the basket declines beyond the buffer.

36% down

"I don't know who picks up these baskets. We're not in the business of predicting the price of platinum," said Steve Doucette, financial adviser at Proctor Financial.

"Obviously the interesting thing is the 20% downside protection. Because you have 20% protected by the buffer, your basket would have to actually decline by 36% before the notes begin to underperform."

He was referring to a 16% decline beyond the buffer, which after applying the 1.25 downside leverage factor would make for a 20% loss. At that point, he explained, the loss would offset the benefit of the 20% capital guaranteed provided by the buffer.

Index, basket

Doucette said that he usually invests in broad indexes and not single commodities.

"There is much bigger risk on individual commodities than on a benchmark," he said.

"This basket of four commodities is probably more volatile than an index, and that's how they can give you better terms.

"But before I would invest in the note, I would have to prove that those four commodities reduce the volatility versus having just one.

"More importantly, I would have to track them in relation to a broad commodity index and see if they are nicely correlated to the index. Then I can say that the basket offers a reasonable representation of the commodities universe."

Doucette said that when he invests in commodities, he wants to stay away from single commodity bets.

"There's a much bigger risk on an individual commodity than on an index. The possibilities of being wrong are huge," he said.

Assuming the basket offers a close correlation to a broad index, the structure would be attractive, he added, noting that the 27.75% cap gives investors a potential 13.87% annualized return.

Because the upside is leveraged at a rate of 1.85, investors will achieve this maximum return if the underlying basket grows by only 7.5% per annum.

Equal weight

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said that he liked the underlying basket. His concern is the leverage put in place when the basket declines by more than 20%.

"Copper is very interesting when we see a lot of infrastructure projects worldwide," he said.

"Brent is on the climb again. Places hit by typhoons and hurricanes start to get back on track again.

"This is a basket that is along the lines of a rebuilding phase in the market cycle. I like it."

Medeiros said that static baskets, like the one used in the notes, present an advantage over benchmarks.

"Most broad indexes are market-cap weighted. This basket is equal weight, which is better if you have a view on specific sectors."

If oil was to appreciate relative to agriculture, he explained, an index would give oil a larger percentage allocation.

With the notes, the oil and agriculture components of this basket would remain unchanged at 25% each.

"This is a static basket, and it's more appropriate for people who have an opinion of where the commodities market is going to go," he said.

"The equal weighting in my opinion is a big plus."

One for one, please

However, Medeiros said that the leverage component of the structure, in particular on the downside, is not attractive.

"I'm just not a fan of downside leverage," he said.

"A 14% annual return on the upside is nice.

"But to me, leverage doesn't add value.

"In this market environment, I don't believe you get rewarded for amplifying your risk."

The notes (Cusip: 06738KZN4) are expected to price on Friday and settle on Wednesday.

Barclays Capital Inc. is the agent with JPMorgan Chase Bank, NA and J.P. Morgan Securities LLC as dealers.

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