Merrill's leveraged notes on Russell 2000 for Svensk are a mildly bullish play on small caps

By Emma Trincal

New York, June 25 - AB Svensk Exportkredit's planned 0% Accelerated Return Notes due September 2011 linked to the Russell 2000 index are for investors mildly bullish on U.S. small caps or eager to diversify away from the S&P 500 index, said Tim Mortimer, managing director at Future Value Consultants.

In both cases, investors in the notes will have a "reasonable appetite for risk," he said.

The payout at maturity will be par of $10.00 plus triple any gain in the index, up to a maximum payment of $12.30 to $12.70 per note. The exact cap will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

Investors will be exposed to any index decline.

High leverage

"If participation is high, which it is here since it's 300%, the product is going to be for mildly bullish investors," said Mortimer.

Mortimer took the example of a cap to be set at 24% - the low end of the 23% to 27% range.

"It would only take an 8% index rise for you to chase the maximum return. And 8% is not that much," he said. "If you're very bullish, if you think the index is going to rise by 20%, you have the wrong product."

No protection

At the same time, risk as measured by Future Value Consultants' riskmap, is "quite high," said Mortimer, scoring 7.74 on a scale of zero to 10.

"The risk is due to the absence of any downside protection. In addition, the underlying index is the Russell, which tracks small stocks and tends to be more volatile," Mortimer said.

Mixed return score

The return rating for the notes is "middle of the road," said Mortimer, at 4.90.

The return rating is Future Value Consultants' indicator, on a scale of zero to 10, of the risk-adjusted return of the notes.

The high level of risk has a negative impact on the return score, he said.

On the other hand, the implied volatility of the Russell 2000 is higher than that of the S&P 500, he noted, and this difference allowed the issuer to offer a higher cap than what investors would have obtained in a similar structure based on the S&P 500.

"The higher the volatility, the higher the cap comes in," he said.

In addition, the cap reflects the risk.

"If the investment was less risky, if you had some downside protection, you would have a lower cap," said Mortimer.

Since both the leverage factor and the cap level are high, the potential for gains is attractive, Mortimer said. Those benefits help lessen the negative impact of risk in the calculation of the return rating.

Win or lose outcomes

Future Value Consultants calculates probability tables for the products it rates using a Monte Carlo simulation. The performance is modeled based on a series of parameters, which include volatility, dividends and interest rates among others.

For these notes, investors have a 56.2% probability of making a positive return.

Inversely, the odds of losing money are 43.8%.

The probability of generating a profit in excess of 15% up to the cap is 51%.

On the downside, investors face a 39.6% chance of losing more than 5%.

High overall

The notes have a good overall rating of 7.57.

The overall rating, on a scale of zero to 10, is Future Value Consultants' opinion on the quality of a deal, taking into account costs, structure and risk-return profile. It's an average of three scores weighted 40% to the value score, 40% to the return score and 20% to the simplicity rating.

The simplicity rating measures, on the same scale, how easy it is to understand or explain a structure.

Value on a scale of zero to 10 is Future Value Consultants' measures of how much money the issuer spent directly on the assets versus other transaction costs such as direct fees and profit margin on the underlying derivative.

These notes carry very high value and simplicity ratings of 9.77 and 8.50, respectively, Mortimer noted.

"The value score is very high here because the assets are priced on a fair-value basis," said Mortimer.

"The overall rating is pretty good, driven by a good value and a reasonable return rating," he added.

Notes versus ETF

Mortimer said that while the notes may be more risky than the average structured product - since they lack any buffer - the risk was no less than that encountered by investors who would buy the exchange-traded fund directly.

"You're not taking more risk than when you buy the ETF. So these notes should be suitable for investors with the appropriate risk appetite and who would be happy to have a small amount of their portfolio allocated to small-cap stocks," Mortimer said.

The notes will price in July and settle in August.

Merrill Lynch, Pierce, Fenner & Smith Inc. and First Republic Securities Co., LLC are the agents.

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