Barclays' principal-at-risk CMS steepener, S&P 500 index-linked notes may signal new trend

By Emma Trincal

New York, Sept. 10 - Barclays Bank plc's upcoming principal-at-risk CMS steepener and S&P 500 index-linked notes due Sept. 18, 2028 caught the market's attention for not offering full principal protection, sources said. Most CMS steepeners, unlike this one, guarantee the return of principal subject to credit risk, they noted.

The initial interest rate is expected to be 10%, according to a 424B2 filing with the Securities and Exchange Commission.

After one year, the interest rate will be equal to four times the spread of the 30-year Constant Maturity Swap rate over the two-year CMS rate, subject to a minimum rate that is expected to be zero and a maximum rate that is expected to be 10%. Interest will be payable quarterly.

Given the type of downside protection, a 50% barrier, investors are in fact at risk of losing their entire investment, sources said, commenting on the prospectus.

At maturity, if the index level is less than 50% of its initial level, investors will lose 1% for every 1% of index decline from that initial level.

Beginning Sept. 18, 2015, the notes will be callable at par on any interest payment date.

Innovative structure

"We've seen them come out with this deal. Having principal at risk on a steepener is not common. But trigger notes have been accepted by the market for some time now," a sellsider said.

"The risk you're taking is the only way to make the pricing work. You have a 15-year maturity, a zero strike, four times the 30-year/two-year spread. The curve doesn't allow you to do that with principal protection."

While some issuers have recently shown similar terms in principal-protected CMS steepeners, the sellsider noted that such products fell into a different category.

"You don't see those terms with principal protection without a dual condition," he said.

He was referring to CMS steepeners in which the coupon amount is not just based on the spread between two CMS rates but also on the proportion of days on which an underlying equity index stays above a predefined threshold. In such deals, the equity index impacts the coupon, not the principal amount returned at maturity.

"You don't have the equity condition here. So putting the principal at risk is how they were able to price the deal," he said.

"Replacing the dual condition by some level of principal at risk is not common. But if it's successful, you'll see more."

Short-term expectations

Michael Iver, chief executive of iVerit Consultancy and former structurer, said that the call protection gives investors two years to realize the maximum return they can get from a steeper curve. But they should be ready to see their notes called on the first call date.

"It's a curve steepener trade for people expecting that with the Fed tapering its long bond purchases, the long-term rates should be rising relative to the two-year. That's generally the view, and it's the view reflected in the note," Iver said.

"However, it has a 10% cap. With the four times spread, the benefit of the steepener ends when the spread between the 30-year and two-year rate hits 2.5%. Anything more than that creates the risk of a call.

"Right now the 30-year Treasury is 3.88% and the two-year is 47 basis points. The difference is 3.41%. When you multiply that 3.41% spread by four, you're way above the cap. You've already hit the cap.

"Obviously, if the Fed tapers and the curve steepens further, the issuer is not going to want to pay 10% for too long. I would expect the notes to be called on the first call date.

"Investors buying this believe that the curve is going to steepen further and assume that they're going to get called. They're doing it to collect 10% for each of the next two years.

"What I find a little bit strange here is that right from the beginning, the way spreads are today, you're already through the cap. Maybe this note is a reflection of the market believing that the Fed tapering is already priced in. If you were to anticipate further steepening, why would you initiate a trade in which you're already capped in?

"I guess this is a 'curve-stay-steep' type of trade.

"You still have the risk of an inverted curve. But if the curve stays where it is or even steepens, at least you get your 10% for the first two years. That's probably the expectation: a high coupon for a short period of time. That means that you don't really have that 15-year exposure. It's more like a two-year and you get called.

"The only way you wouldn't get called would be if the curve was inverted. That would be a negative outcome as you wouldn't earn a coupon on a negative spread."

Risk disclosure

Tom Balcom, founder of 1650 Wealth Management, said that the product, although attractive for some investors, could be complex for investors not familiar with the product.

"It's a yield-oriented note. The problem I have is trying to explain it to a client," he said.

"It's definitely appealing for someone looking for higher yields than what Treasuries or CDs have to offer.

"The spread between the two rates with the four times factor at least gives you a few percentage points. It sounds good.

"But there are risks that need to be explained.

"Your principal is at risk. That's not the worst part. I doubt that 15 years from now the S&P 500 would be half of today's levels.

"The duration of the notes, 15 years if it doesn't get called, would be a concern. If rates pick up, clients should be aware of the principal erosion. If rates do rise and you want to sell before maturity, you have this interest rate risk to consider. It should really be for buy-and-hold investors, even though you may not hold it for long if it gets called.

"The call is another risk that the investor is taking. How long does the investor want to collect the coupon and what type of coupon does he expect to receive? What you're trying to accomplish will determine whether it makes sense or not.

"Finally, you have the risk of an inverted curve, the risk of getting no coupon at all.

"All those things have to be taken into account.

"I have no problem with the note as long as the adviser explains the risk. This note is a solution for the yield-starved investor. It's fine if you know the risks and the cost."

Barclays is the agent.

The notes will settle Sept. 18.

The Cusip number is 06741TJ96.

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