Barclays’ CDs tied to 10 stocks may offer up to 8% yield, but risks seen in correlation, tenor

By Emma Trincal

New York, June 10 – Barclays Bank Delaware’s certificates of deposit due June 29, 2022 linked to a basket of stocks provide an opportunity to earn up to 8% a year in coupon depending not only on the performance of the basket but on a specific method used to calculate the return of each component, sources said.

The equally weighted basket includes Apple Inc., Caterpillar Inc., Coca-Cola Co., ConocoPhillips, Ford Motor Co., Intel Corp., Pfizer Inc., Qualcomm Inc., Target Corp. and Verizon Communications Inc., according to a term sheet.

The CDs will pay a coupon each year equal to the average of the performances of the stocks, subject to a minimum coupon of 0.5%.

If a stock's return is greater than or equal to zero, its performance will be equal to the return cap. If a stock's return is negative, its performance will be the greater of the stock return and negative 15%. The return cap is expected to be 7.5% to 8% and will be set at pricing.

Investors will receive par at maturity.

Floored puts

“These are old structures,” a market participant said.

“It’s not a bad deal. It’s just the way they calculate the return for each stock that’s a bit different.

“There are many ways to look at this, but essentially the investor is selling floored puts on the 10 stocks in return of a premium paid out as coupons.

“You’re selling puts on all 10, and the amount of premium is your 8% cap.

“If the put is out of the money, they give you 8%.

“If it’s in the money, they take the return performance with a floor of 15%.

“What the client is doing is selling the negative performance against 8%. If half of the basket goes down, you get a negative return.”

He offered a simplified example, taking a basket with only two stocks.

If one of the stocks finished down 15%, its performance would be negative 15%. If the other stock rose by the same percentage, the return would be 8%.

“One stock goes down 15%, the other goes up 15%. Normally your average would be zero. In this case you would be negative 7%, so it’s a deal against dispersion,” he said.

The main risk factor in this structure is if the stocks have little or negative correlation between one another, he said.

The term sheet warned about the low correlation risk, stating that in this scenario, the price declines in some of the stocks may offset the gains of others.

The impact of low correlation is exacerbated by the structure itself, according to the term sheet, pointing to the discrepancy between the 8% cap and the 15% floor for the calculation of each stock’s performance. The asymetrical return calculation gives investors a greater exposure to a negative return for each stock than to a positive performance, the term sheet said. Ultimately, the risk is to receive a low coupon, which is the only return available to investors.

“If stocks move in different directions and a lot, it goes against the client. You have more exposure to losses than to gains,” the market participant said.

“Even though all stocks are equally weighted, it’s not a basket deal really.

“Investors are buying correlation. They want the stock to stay the same. If they do, you can easily get your 8%. What you don’t want is stocks moving up and down a lot.”

The market participant said there was nothing “unfair” about the structure. The asymmetry between the cap and the floor was designed to enhance the yield.

“That’s how they can give you the 8%,” he said.

“If instead of flooring the downside at 15% they floored it at 30%, the price would be even better. You would get a much higher coupon.

“The important thing in how these deals price is where they floor the downside.”

Blue chips

Paul Weisbruch, vice president of ETF/options sales and trading at Street One Financial, downplayed the risk associated with a low correlation. Instead, he pointed to the length of the product.

“These stocks are spread across different sectors. There’s no indication on how they picked the stocks, but it probably has something to do with historical correlation,” said Weisbruch.

Three of the stocks are in the information technology sector, two are in the consumer discretionary sector, and each of the five other names belongs to a separate sector – industrial, energy, consumer staples, health care and telecommunications.

“Not much correlation here, at least by sectors. But I’m not sure it adds that much risk because you’re dealing with large caps, S&P 500 types of stocks,” he said.

“Historically, names in the S&P are correlated. If anything the seven-year term would tend to create a greater correlation. If it was a short-term product, anything could happen. Stocks could move all over the place, and correlation could be out of control. Long term it’s pretty safe to say that they stay correlated.”

Long tenor

Weisbruch said he is more concerned about the impact of a new market cycle over the seven-year period.

“Today the market recouped days of losses. We have very little volatility. The market reverses itself in a hurry to erase price declines. We barely have pullbacks. But that’s now,” he said.

“That’s because the Fed and the central banks are tampering volatility. We know it can’t last forever. And that’s where the risk exists. Most people expect interest rates to normalize in the next one to two years. In seven years, we could be in a new cycle in the market. So I’d say it’s a long-term exotic product. You’re exposed to market risk. Seven years from now anything can happen.”

Barclays is the agent. Incapital LLC is distributor.

The CDs will price June 24 and settle June 29.

The Cusip number is 06740A6N4.

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