Deutsche Bank’s leveraged notes tied to S&P MidCap 400 to outperform in small growth scenario

By Emma Trincal

New York, Dec. 4 – Deutsche Bank AG, London Branch’s 0% Accelerated Return Notes due February 2017 linked to the S&P MidCap 400 index are designed for investors who expect lackluster index returns and seek to outperform the market, said Tim Vile, structured products analyst at Future Value Consultants.

If the index return is positive, the payout at maturity will be par of $10 plus 300% of the index return, subject to a maximum return that is expected to be 10% to 14% and will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the index return is negative, investors will be exposed to the decline.

Mildly bullish

“The upside potential on this product is quite rewarding for a 14-month,” said Vile.

“If the cap is in the mid-range at 12% you get a little bit more than 10% a year. If the index increases by only 3.5% a year, which is really not that huge, you hit your 12% target return. The leverage here maximizes the chances of hitting the cap.

“If the index is not down, you’re guaranteed a reasonable amount of return with only a modest performance.”

While investors must have limited return expectations, they cannot be risk-averse, he noted.

“They have full downside exposure. They have to be willing to take on that risk,” he said.

“These are moderately bullish investors with a certain conviction in the market direction over the short term. They don’t expect the market to be up a lot; otherwise, they would choose an uncapped note or a note with a higher cap...maybe with less leverage or a longer maturity.

“Still, this is not for bears. You still have to be bullish.”

The underlying index is highly correlated with the S&P but has outperformed the large-cap benchmark most of the year until the end of October when the S&P began to outperform.

Both indexes have not shown growth for the year with the S&P up 1.50% while the MidCap 400 has remained flat.

“If the next 14 months show a similar trend, this note with its three-times leverage will outperform the S&P MidCap 400,” he said.

“As long as the index doesn’t generate double-digit returns, you will do better with this note than with an index fund.”

Riskmap

The product is scored against its peers, which in this case are leverage return products. Future Value Consultants also compares each score with the average score for all products. This last group encompasses all structured notes recently rated by the firm across all structure types.

To assess risk, the research firm adds two risk components – market risk and credit risk. The resulting riskmap measures risk on a scale of zero to 10 with 10 being the highest level of risk possible.

The market riskmap is “surprisingly” close to the average of the same product type at 2.90 versus 2.82, he said based on his research report.

“You would have thought it would be a lot higher given that there is no barrier or buffer. It may be because other leveraged products do not have protection at all or may be tied to more volatile underliers,” he said.

Credit risk

The credit risk of 0.45 also “surprised” as it is very close to the average for the same products, which is 0.42, he noted.

This muted result is due to two factors offsetting one another, he explained. On the one hand, the short maturity reduces credit risk exposure. On the other hand, Deutsche Bank’s creditworthiness is disappointing compared to most U.S. banks, he said.

The five-year credit default-swap spreads for Deutsche bank are 92 basis points, according to Markit. In comparison, the three U.S. banks with the widest spreads are Morgan Stanley and Goldman Sachs, which both show spreads of 85 bps and Citigroup with spreads of 84 bps.

“We end up with a riskmap that’s slightly higher than average but not by much. That’s because the differences in risk with the product type average are quite small,” he said.

The notes have a 3.34 riskmap while the average for the product type is 3.24. It is 3.64 for all products.

“This riskmap is relatively average. This is not a product that shows excessive levels of risk. Compared to all products, it’s less risk, possibly because you’re comparing the notes with riskier structures such as reverse convertibles.”

Return score

Future Value measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions – neutral assumption, bull and bear markets, and high and low volatility environments.

The notes have a 6.81 return score versus an average of 7.11 for the product type, according to the report.

“The return score is lower. Since it’s a risk-adjusted return measure it could be due to excessive risk or insufficient upside,” he said.

“In this case the riskmap is not the factor. Risk is higher than average but not overly high. The cap on the other hand is what leads to the lower return score. With a higher cap or no cap, the return score would have been much more competitive.”

Price score

For each product, Future Value computes a price score that measures the value to the investor on a scale of zero to 10.

This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

At 6.91 the price score is higher than the 5.97 average for the product type.

“The average price score suggests that this product offers more value to investors than other leverage notes,” he said.

“The short maturity is not an advantage because the fees have to be amortized over a brief period of time.

“So if the score is good, it’s because pricing is good. The issuer spent a reasonable amount of money on the options, especially for the purchase of three times the upside.”

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.

The notes have a 6.86 overall score while the average for the product type is 6.54.

“It’s a decent product for reasonably bullish investors. It doesn’t give you unlimited upside or downside protection. But it offers the opportunity to significantly outperform even if the index doesn’t rise much,” he said.

“If the S&P Midcap 400 index is up only 5% over the next 14 months you can expect up to 14% in return which is quite high.

“For those mildly bullish investors who want exposure to this asset class, this product offers a chance to capture excess return over a short period of time.”

Merrill Lynch & Co. is the agent.

The notes are expected to price and settle in December.

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