Wells Fargo’s variable annual interest CDs tied to 10 stocks offer alternative to fixed income

By Emma Trincal

New York, July 26 – Wells Fargo Bank, NA’s variable annual interest certificates of deposit due Aug. 1, 2024 linked to 10 stocks allow investors to get a higher coupon than the guaranteed rate of a fixed-income instrument in exchange for the sacrifice of a portion of the fixed income.

The underlying companies are Apple Inc., AT&T Inc., Bristol-Myers Squibb Co., Caterpillar Inc., Cisco Systems, Inc., Coca-Cola Co., Merck & Co., Inc., Nike, Inc., Procter & Gamble Co. and Starbucks Corp., according to a term sheet.

The CDs will pay an annual coupon equal to the sum of the stocks’ weighted component returns, with a minimum interest rate of 1%.

If a stock’s underlying return is at least zero, its component return will be equal to the fixed component return of 4.5% to 5%, with the exact percentage to be set at pricing. Otherwise, its component return will be equal to its underlying return, with a floor of negative 15%.

The payout at maturity will be par.

Mini reverse convertibles

A market participant explained how the CD structure works first at the “stock level,” with the cap and floor applied to each component, and second at the “global” level, which determines the amount of the variable coupon paid each year.

“It’s a little bit like 10 mini reverse convertibles in the package. Imagine each coupon as its own reverse convertible,” he said.

At the “micro” or “stock” level, the structure for each of the 10 stocks is similar to the sale of a put spread.

A short put spread position is an option strategy that combines the sale of a put with the purchase of another put at a lower strike.

“You’re selling an at-the-money put. You’re buying back a put at 85,” he said.

“That way you can’t lose more than 15 on each stock.”

The “at-the-money” strike represents the 100 initial price at the trade date.

The put sale at the 100 strike provides the 5% contingent coupon, which investors get only if the stock finishes above 100.

“You do that for the 10 stocks,” he said.

“At the global level, if the weighted average is below 100, you get that 1% minimum coupon.”

The moving parts of the structure are a digital coupon in addition to a put spread, he said.

Compared to a CD

Sources compared this payout with other fixed-income instruments. No matter what the comparison, using the variable rate of the CDs is done in an attempt to get a higher coupon than a similar fixed-income product. The risk is to receive less.

This market participant compared the structured CDs with a standard CD paying a fixed rate. He estimated the average seven-year CD rate to be around 2.5%.

“Let’ say you buy the Wells Fargo CD versus a plain vanilla CD with a 2.5% coupon. Each year, you only have 2.5% to lose. But since they’re giving you a minimum rate of 1%, your risk in terms of coupon loss is only 1.5% because the other 1% is guaranteed,” he said.

Whether the chances of earning the 5% maximum coupon are high remain to be seen. But investors are risking 1.5% in annual coupon to achieve that goal, he concluded.

Boost and range

Tom May, partner with Catley Lakeman Securities, said the probabilities of getting the capped coupon are probably low given the way the return is calculated on a stock-per-stock basis.

“By making the autocall 5% and the floor -15%, the structure is skewed. Your floor is lower than your cap,” May said.

But there are reasons behind this asymmetry.

“They have to do that to pay you the interest rate, the minimum coupon and the principal protection. As we know, interest rates are still very low.”

The digital on the upside helps offset some of the imbalance between the floor and the cap levels.

“At least the 5% is a digital, so you get the boost even with a small increase, while the downside is equal to the falling stock price. That makes it a better trade than if it was a jump on both ends,” he said.

Coupon at risk

May then compared the CDs with a bullet bond from the same issuer. Wells Fargo’s seven-year corporate bonds show a yield of about 3%.

“You’re guaranteed 1% for the possibility of getting 5%,” he said.

“If you choose the bond, at least you’re guaranteed the 3%.

“It seems pretty clear which one makes the most sense, although it really depends on the investor.”

But such comparison is not “fair” because CDs offer some protection against counterparty risk.

The Federal Deposit Insurance Corp. provides insurance against the issuer’s default. It covers up to $250,000 per depositor.

“Given that, it makes more sense to compare this CD with Treasuries,” he said.

The seven-year Treasury yields 2%.

“You buy that CD. It means you’re happy to give up 1% of your guaranteed coupon for the chance of getting another 4%.

“Like everything else, you have to look at your probabilities of winning this bet.

“But it’s not a risky trade because your principal is protected.”

Incapital LLC is the distributor.

The CDs are expected to settle on Tuesday.

The Cusip number is 94986TW52.

© 2015 Prospect News.
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