Barclays’ contingent income autocallable notes linked to Tesla show poor risk-reward profile

By Emma Trincal

New York, July 14 – Barclays Bank plc’s contingent income autocallable securities due July 23, 2015 linked to the common stock of Tesla Motors, Inc. offer a disappointing risk-reward profile given the strong volatility of the underlying stock, sources said.

While income-seeking investors may be attracted to the potential 16.55% annualized return offered by the notes, the sources see the risks as magnified by the wide up-and-down moves of the underlying share price.

If Tesla shares close at or above the downside threshold level, 70% of the initial price, on a quarterly determination date, the notes will pay a contingent payment of 4.1375% for that quarter, according to an FWP filing with the Securities and Exchange Commission.

If Tesla shares close at or above the initial price on any quarterly determination date other than the final one, the notes will be automatically redeemed at par of $10 plus the contingent payment.

If the notes are not called and the final price is greater than or equal to the downside threshold level, the payout at maturity will be par plus the contingent payment. Otherwise, the payout will be a number of Tesla shares equal to $10 divided by the initial share price or, at the issuer’s option, a cash amount equal to the value of those shares.

Monday rally

Tesla is a manufacturer of electric cars. Its share price has jumped 75% in one year and is up more than 50% this year to date. Just on Monday, the share price rallied 4%.

Market analysts attributed the rally to a news report posted on Barron’s website on Saturday stating that China will require that 30% of the government auto purchases be electric vehicles.

“The stock is getting a Barron’s bounce today,” said Richard Hilgert, an auto analyst at Morningstar.

The boost in share price did not come as a surprise for other analysts.

“I didn’t even pay attention. It’s a volatile stock. Nothing out of the ordinary for a stock like this,” said an analyst with a New York-based European bank.

Paid 50% less

Philip Davis, options specialist at Philstockworld.com, said that investors in the notes are taking on too much risk without getting enough return.

He assumed a current stock price of $228.63 a share, a price hit by the stock in the late morning on Monday.

Rounding up the price to $230, the 70% downside threshold would represent a roughly $160 strike.

In this scenario, the issuer would pay investors 4.1375% on any quarterly observation date in which the stock would be above the $160 price, based on the terms of the notes.

“They pay you 4.14% per quarter, or 16.55% a year. Note today’s move just in one day,” Davis said.

The stock moved up 6% intraday on Monday from a low of $215.73 to a high of $228.75.

“They’re selling a put at the $230 strike. They have a downside risk between $230 and $160 that they need to cover,” he said, referring to the underlying price range within which the issuer has to pay the quarterly payment.

The option trade equivalent to this structured note is a put sale, he explained. The investor shorting the put at a specific strike is betting that the stock will close above the strike on a particular date. He gets paid a premium for taking on the risk. If he is wrong and if the stock closes below the strike price, he will be “put” the stock, which means that he will be obligated to buy the stock at the higher strike price, he said.

“Right now there is no July 2015 put. They’re taking advantage of the fact that you can’t find a one-year put. But let’s see. If you sell the January $230 put right now, you’re collecting a $31 premium. So you’re getting paid $31 for 186 days. That’s a 13.5% rate of return in six months,” he said.

The term January $230 referred to an option with a strike price of $230 and an expiration date on that month.

“Over the same period of time, over six months, they’re paying you 8.3%. That’s almost half of what you would be getting if you put on the trade yourself,” he said.

The six-month payment was obtained by adding together two quarterly contingent payments of 4.1375% each.

Margin

“In addition, they’re taking 100% of your principal up front, while they only need to put 20% down for their margin option trade. They can play with the rest,” he said.

Davis conceded that one possible advantage of the note versus trading options is to reduce the amount of principal at risk. Trading options requires the purchase or the sale of at least one contract of 100 shares each. For a stock trading at $230 per share, the minimum investment in options would be $23,000. The notes, on the other hand, require no more than $1,000 as a minimum investment.

“Note that the option trader can reduce the amount of money they have to put to work using margin,” he said.

Margin requirements vary based on the option type, the strategy and the brokerage firm.

“Let’s assume a 20% margin rate for a $230 put. Instead of having to invest $23,000, you can just put $4,500. There is margin risk involved, but do you have to pay them 50% to take that risk?” he said.

“I guess it depends on who you are, but I don’t think you can benefit from products like that if you’re small and unfamiliar with stocks and options.”

Barrier versus buffer

Davis said that the notes are more risky than a short put position given the contingent nature of the protection.

“The notes give you a 30% protection, but it disappears if you hit that 30% threshold. That’s much more risky than writing a put,” he said.

“Say you sell the put at a $160 strike from a $230 at-the-money price. The stock closes below $160. You’re down by more than 30%. You lose one to one from the initial price. You are on the hook for that entire $230 down to zero. Your downside is worse than if you were selling the put. If you were selling the put at a $160 strike, you would keep that 30% downside protection in your pocket. You would lose from $160 and down as opposed to $230 and down. That’s a big difference!

“Think about how valuable your downside protection is with a stock like Tesla.

“It has almost 60% in implied volatility. The 30% downside protection they give you is in the mid-range of the price moves. It’s half way.

“This is a stock that can move 10 points in one day. Look at [Monday]. We’ve actually started to short it and wrote some calls on it.”

Over the past 12 months, the share price of Tesla Motors has dropped more than 30% twice within a period of about two months, according to the chart.

The stock fell by 38% from Oct. 1, 2013 to Nov. 26, 2013. This year, the share price dropped 30.2% from March 4 to May 9.

“I stay miles away from these momentum stocks. There’s too much danger there,” he said.

Investors seeking income have less risky alternatives to explore, he said.

“Pfizer for instance pays a 3.5% dividend yield. You only pay 50% down when you buy it on margin, so that’s an equivalent yield of 7%. Even if it’s not 16.5%, you can easily sell puts and calls and earn a nice extra 10%. Meanwhile, you’re not on the hook with this 30% downside threshold; you can get in and out, and you have no credit risk,” he said.

Big picture

Scott Cramer, president of Cramer & Rauchegger, Inc., who invests in structured products, said that he has no interest in single-stock-linked notes.

“I don’t think it’s an appropriate use of structured notes,” he said.

“I use structured notes that are tied to an index or several indexes as a way to make portfolio allocations. With this, they’ve created some kind of option hedge on one particular stock. If I wanted to take a bet on a stock, I’d rather play the stock or the option directly.”

Cramer said that his opinion is not the result of his view on the stock or on the structure.

“It’s more of a big picture view. I don’t like these trades. I’m not interested in investing in notes that are repackaging options. I’d rather play to the overall strategy of a portfolio than to play to the overall strategy of a trader. If you’re a savvy trader, do it yourself. But keep in mind that this is a volatile stock. If you use the notes, you are locked into the trade. If the stock starts to do well, you’re going to be called out. And if it happens to be down 30% at maturity, you’re in a lot of trouble,” he said.

Barclays is the agent with Morgan Stanley Smith Barney LLC handling distribution.

The notes are expected to price Friday and settle July 23.

The Cusip number is 06742W414.

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