Barclays' buffered leveraged notes tied to Russell 2000 limit gains for safer small-cap play

By Emma Trincal

New York, April 8 - Barclays Bank plc's upcoming 0% buffered Super Track notes due Oct. 31, 2011 linked to the iShares Russell 2000 index fund should attract investors moderately bullish on the U.S. small-capitalization equity market and seeking to diversify away from and possibly outperform the S&P 500 index, sources said.

The payout at maturity will be par plus double any fund gain, subject to a maximum return of 12% to 14.5% that will be set at pricing, on April 27, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the fund declines by 10% or less and will be exposed to any decline beyond 10%.

Barclays Capital Inc. is the agent.

Russell rally

Market participants noted that several issuers since the beginning of the month have announced deals linking notes entirely or partially to the Russell 2000 index.

The reason for this may be performance, they said.

The iShares Russell 2000 index fund, which replicates the performance of the Russell 2000 index, is up approximately 12% so far this year.

In comparison, the iShares S&P 500 index fund has only gained about 6.5%.

Better terms

According to structured products research firm Future Value Consultants, the Russell 2000 index and the S&P 500 index have an underlying volatility of 35.4% and 32.9%, respectively.

For some, the equity cycle easily explains why the small-cap benchmark would outperform the large-cap index.

"Small caps always head us up before large caps take over. It's amazing that things can be normal in a crazy environment like this one," said Steve Doucette, financial adviser at Proctor Financial.

"You'll see a lot more structures coming out with the Russell. What makes options worthwhile is when there's more volatility. With the Russell underlying, you can get more range on these notes. That's probably why people are switching underlying. You can get better terms," Doucette said.

Volatility and uncertainty

But whether the rally in small-cap stocks is going to last or not is "hard to tell," said Doucette.

"Getting to decide whether to invest in it or not has to do with how bullish we are on the overall market. That's the question of the day," he said.

"I appreciate a little bit of a buffer in case the market is going to go lower," he said.

Doucette assumed a 13% cap based on the approximate mid-point in the 12% to 14.5% maximum return range.

"But a 13% cap concerns me because you can give up a lot of performance if your underlying goes up. If the underlying is up less than 6.5%, then it's nice to have the double leverage. But after that, the two-time leverage is not going to work for you," he said.

Barclays announced a similar product also linked to the iShares Russell 2000 index fund, according to an FWP filing with the SEC.

This other product also matures on Oct. 31, 2011 and offers a two-times leverage factor. But it has no buffer and its cap, at 17.7% to 20.25%, is much higher.

"If the market is range-bound, the lower-cap deal would be very good. If the rally picks up in momentum, then you would be better off with the 19% cap and no buffer," said Doucette.

"We're not going to make that call now because as we move forward, it's hard to predict in which direction the market is going," he said.

"We still have exposure in similar notes. They are capped with a small buffer, and they have performed well," Doucette added.

"When some of our notes come due six to eight months from now, then we will consider those products on a case-per-case basis. But we're not moving in that direction at this time."

Not too bullish

Suzi Hampson, structured products analyst at Future Value Consultants, said that the buffered and leveraged notes with the hypothetical 13% cap give investors a chance to outperform the index fund under a modest growth scenario.

But investors need to have a view on the market before investing, she said, because the notes are not a good fit for bulls.

"If you look at the Russell 2000 [fund], up 12% in the last three months, you mustn't be too bullish to invest in a note that limits your gains to 13%," said Hampson.

If the notes were to mature today, she said, a non-leveraged version of the notes would yield the actual index fund gain of 12% while the capped and leveraged product would earn 13%.

"As of now, you wouldn't be much better off with the leverage," she said.

"You only need the index [fund] to gain 6.5% in 18 months to maximize your return. That's not being very bullish," she said.

"Clearly, this 13% cap should appeal to investors who think the index [fund] will slow down in the next year-and-a-half," Hampson noted.

April deals

The S&P 500 index remains the underlying of choice for equity index-linked notes.

Out of the $19 billion of structured notes issued so far this year, products linked to the S&P 500 represent $2 billion, or 10.53%, of the volume, according to data compiled by Prospect News.

By comparison, notes linked to the Russell 2000 represent $329 million, or 1.72%.

But market participants are predicting that more deals offering notes tied to the Russell 2000 will come to market, whether investors will demand this underlying for diversification or performance purposes.

Since the beginning of April, issuers have announced 10 deals linking their planned notes solely to the Russell 2000, according to data compiled by Prospect News.

Examples of recent announcements of Russell 2000 index-linked notes include Morgan Stanley's plans to price 0% autocallable knock-out notes due May 12, 2011 with a 7% call premium.

HSBC USA Inc. said it will price 0% buffered Accelerated Market Participation Securities due July 28, 2011 with a payout at maturity of par plus double any index gain, up to a maximum return of 13.5% to 18.5% and with a 10% buffer.

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