Barclays' $19.29 million worst-of notes linked to Euro Stoxx 50, FTSE 100 offer balanced risk

By Emma Trincal

New York, Dec. 10 - Barclays Bank plc's $19.29 million of 0% annual autocallable notes due Nov. 25, 2016 linked to the lesser performing of the Euro Stoxx 50 index and the FTSE 100 index may have appealed to investors who want yield while getting some contingent protection should the market turn downward, sources said.

Investors who expect a limited correction and flat market may benefit from the product but should be aware of the risks associated with the "worst-of" payout, said Tom Balcom, founder of 1650 Wealth Management.

The potential return is attractive, and some of the structural features help offset part of the risk, giving investors a "worthwhile trade-off," said Michael Iver, chief executive of iVerit Consultancy and a former structurer.

The notes will be called at par plus 14% per year if each index closes at or above its initial index level on any annual call valuation date, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par unless the worse-performing index finishes below the 80% barrier level, in which case investors will be fully exposed to the decline of the worse-performing index.

"If you're having a range-bound view, this could make sense," Balcom said.

"But you really have to be aware of the downside risk because if just one of the two indexes goes down significantly, then you're out of luck. But if you anticipate that the market will trade sideways for three years, in that case you're fine.

"In any event, this is not for anyone with a strong view. Avoid it if you're bearish. The risk of the barrier being breached is too great. And don't use it if you're ultra bullish either because your return is capped at 14% a year."

Perhaps the biggest red flag with the note would be to misallocate it, he said.

Equity bucket

"I would see it as a proxy for a long-only position for the equity asset class. I would use it as long-only replacement. I wouldn't advise anyone to use this as fixed-income replacement," he said.

"Anyone buying fixed income wants some kind of yield and wants less risk. The potential yield is attractive here. But losing 20% or more of your principal is not going to make any fixed-income investor very happy. In fact, you, as an adviser, would get fired."

"It's for a long-only equity replacement only. As an equity replacement, you take the long-only position off the table. After all, you do have the protection here even though it's tied to the worst-performing index. It's still a protection of 20%. Besides, the correlation is pretty high. It's a good way to get the protection."

Even if they end up getting their entire investment back at maturity, investors still have no guarantee that they'll receive the call premium, he said. That would be in the absence of a call and if the worst-performing index was to close lower than its initial price but above the trigger.

For Balcom, the protection offered by the notes makes the risk worth taking as long as the investment is seen as an equity replacement in a portfolio.

"If you seek equity exposure and have a note like this one maturing in March 2009, you get par back, you haven't gained anything but you haven't lost anything either, I think you would be pretty happy. It depends on whether we have a simple or a more severe correction. If the worst of the two indexes falls by less than 20%, being able to outperform the market is an excellent thing for an equity investor," he said.

Market slightly off

Iver agreed that the notes are best for investors who do not anticipate wild market moves. The main purpose is to get the 14% annualized return with a complex structure including the automatic call, a long correlation exposure and a short volatility play on the upside and on the downside.

"With rates so low, issuers are creating big-coupon deals with investors selling volatility; this one adds correlation, too," Iver said.

"This may be appropriate for someone who thinks the market will trade slightly off but not all the way down by 20% to trigger the worst of."

Short vol

On the upside, he said, investors sell volatility.

"The issuer includes three annual call dates giving investors three annual opportunities to see their notes called," he explained.

"Getting 14% a year is a fine return in this environment, in my view," he said.

"You're selling away the upside above 14%. If the market trends up, you're capped out at a 14% per annum return.

"But here is one thing that makes this cap even more attractive: Unlike other structures where the cap is a fixed percentage, this is an annualized cap of 14% on the upside."

Depending on when the notes get called, investors may receive a 14%, 28% or 42% call premium, he said, referring to the prospectus.

"It's better than other structured notes that have a fixed upside nominal cap."

The 80% barrier also offers an additional appeal not always seen with these products: Instead of a daily observation, the barrier observation is only final, he noted.

"On the downside, the volatility that you're selling is the worst of that can hurt you. If you hit that trigger at the end, you end up with the worst-performing index.

"But the interesting part of this deal is that you're not symmetrical in terms of the volatility you're selling.

"You're selling this trigger that can hurt you, but it's only a one-time look at maturity as opposed to the three annual observation dates on the call."

Long correlation

In addition to the non-fixed value of the call premium and the fact that the barrier is a European option exercisable only at the end, Iver pointed to another positive trait of the deal: the high level of correlation between the FTSE 100 index and the Euro Stoxx 50 index.

"These two are highly correlated, and it's a good thing," he said.

"It's the FTSE and the Euro Stoxx. You would expect them to be highly correlated. After all, it's not as if you had Asia and Europe."

The two underlying indexes have a 0.916 correlation coefficient, according to the CME Group, he noted. Correlation is perfect when the coefficient is one. Negative correlation is at its maximum when the coefficient is minus one.

"You're better off having those indexes highly correlated in a worst-of structure," he said.

"Take the following example: On one extreme, you have two indexes perfectly correlated. It's just like having one index instead of two. One index and one opportunity to hit the barrier only.

"On the other extreme, if the two are negatively correlated, you now have two opportunities to hit the barrier.

"The higher correlation makes your structure more similar to one that would be tied to only one index.

"Having a 0.91% coefficient is pretty good. It reduces the risk. You are long correlation in these worst of, and so the higher the correlation, the better for you. That's what we have here at least now.

"However, you need to look at correlation from a dynamic standpoint. The degree of correlation may change over the life of the deal. If it was to decrease, it would be bad for investors as it would increase the likelihood that one of the two indexes would hit the worst-of trigger.

"The good thing for this deal is that correlations tend to increase when markets trade downward."

For investors seeking equity exposure to the two indexes with some protection on the view that the bull market may have neared or reached its top, the notes offer an opportunity to generate good returns, he concluded.

2014 and beyond

"I like the deal," he said.

"The idea of getting a potential 14% return per annum is attractive.

"Obviously, you're expecting some kind of market decline but a moderate one.

"Everything in this market is going to be related to the reaction to the Fed tapering. The reason the market has been up all year is because the Fed has been very accommodative.

"One of the final good parts of the deal is the three-year duration. Even if the equity markets were to trade off in response to the Fed tapering, investors still have three years to see this view played out."

The notes (Cusip: 06741T2X4) priced Dec. 5.

Barclays was the agent.

The fee was 2.5%.

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