Barclays' worst-of autocallables linked to two ETFs show high return score due to correlation

By Emma Trincal

New York, Feb. 22 - Barclays Bank plc's 0% annual notes due March 1, 2016 linked to the iShares MSCI EAFE index fund and the iShares MSCI Emerging Markets index fund offer an attractive risk-return profile to investors due to the relatively high correlation between the two reference assets, said Suzi Hampson, structured products analyst at Future Value Consultants, even though the structure used in the notes is risky as a category.

The notes belong to the "worst-of" category, in which the issuer references the note to several underlying assets.

The notes will be called at par plus an annualized premium of 10.4% to 12.4% if both funds close at or above their initial levels on any annual call date, according to a 424B2 filing with the Securities and Exchange Commission.

If the notes are not called and the worst-performing fund finishes at or above the 75% trigger level, the payout at maturity will be par. Otherwise, investors will be fully exposed to the decline of the worst-performing fund.

Long correlation

"These worst-of autocallables are basically a correlation trade," Hampson said.

"The best outcome for the investor is to get called in order to pocket the call premium and close the risk associated with holding the notes.

"For the investor, a worst of is beneficial when there is a high correlation between the underlying assets. Remember, the call only occurs if both funds are above 100. If they move in the same direction, the likelihood for this to happen is greater. That's what you want as an investor. You are long correlation."

Hampson looked at the correlation between the EAFE ETF, a fund giving investors exposure to the equity of developed countries, and the Emerging Markets ETF, which represents emerging market stocks, and found a one-year historical correlation between the two of 85%.

"It is somewhat surprising because you wouldn't expect those two funds to be highly correlated given that they represent different themes, different regions," she said.

"But 85% is quite high if you compare it for instance to the correlation between the S&P 500 and the FTSE, which is 80%.

"It's based on weekly observations over one year, and it may not give you the whole picture, but still, we have more correlation than you would expect."

She said that structurers of worst-of autocallables use two or several underlyings as a way to increase the potential return because more than one reference asset is going to increase the level of risk.

"When the two underlying are highly correlated as it is the case with this product, it suggests that you have more chances of being called, which lowers the risk. Of course they can both go down. Correlation doesn't define the direction of the reference assets, but it certainly determines the probability of the autocall to occur," she said.

The notes are in a riskier category of autocallables but managed to be less risky than average due to the high correlation between the two funds.

However, investors do not always understand the implications of correlation on risk, she said.

"The fact that a high correlation lowers the risk is quite hard a concept for an investor to grasp," she said.

"Autocallables have been around for quite a while. They are well-known structures, at least for people investing in structured products. But worst-of autocallables require a more sophisticated investor in order to understand the correlation risk they're taking on. The benefit of two underlying versus one is a higher potential return," she said.

"Investors buying worst of instead of a normal autocallable product are simply looking for more aggressive returns.

"You can somewhat lower the risk when correlation is high. But as a product type, you're still going to have more risk with a worst of than you would have with a regular autocallable all things being equal."

Investors in these notes - as most autocallable investors - can outperform the market even without growth.

"They don't have to be very bullish at all," she said.

"In a flat market, the product really performs well. Even if none of your two funds goes up, you can still get 10% in one year without any market growth."

Less risk

When compared to the same types of products - which are worst-of notes recently rated by the firm - the notes are less risky than their peers even if the product type is risky on average, she said.

She reached that conclusion from an analysis of the riskmaps.

The riskmap is Future Value Consultants' measure of risk. It reflects the risk associated with the product on a scale of zero to 10. The higher the riskmap, the higher the risk of the product. This indicator is the sum of two risk components: market risk and credit risk.

At 3.90, the product's riskmap is much lower than the 4.53 average riskmap for worst-of notes.

"The risk comes from the fact that if you don't kick out, your repayment is based on the worst performer of the two. You'd have to be prepared to lose principal in that case," Hampson said.

"As with any autocallable, the kick out reduces the risk of losing principal."

Between market risk and credit risk, it is the low market risk that contributes to the product's lower-than-average level of overall risk, she said.

The market riskmap for the notes is 3.19, compared with 3.89 for the average of the same product type.

On the other hand, the credit riskmap is a little higher at 0.71 compared to the average of 0.64.

"The generic product type is risky because you can have three different underlying, and for each underlying you add the risk increases," she said.

"This product however is quite conservative," she added, citing a combination of factors that reduce market risk.

"First you have a 75% barrier, which is quite generous even for a three-year product. Then you have the fact that the barrier is final as opposed to being measured throughout the life. Finally, you have the choices of underlying. Even though you have emerging markets, this is not the most volatile asset compared to riskier funds, indexes or stocks," she said.

The higher credit riskmap was due to the longer-than-average duration, she said.

Return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

The best scenario with these notes is "high growth" because it increases the probability of an early redemption, she said.

Under the high-growth scenario, the report shows a 59% chance of the autocall kicking in on the first year, followed by an 11.4% probability for the second year. If the notes have not been called during the first two years, the likelihood of an autocall drops to 6.4% for the third year, according to the report.

"Think about it this way: if you don't kick out in the first year, it means that both funds are below 100. On the second year, not getting called means that you've been below 100 two years in a row. It doesn't look good for the third year," she said.

"This is why investors are looking to get kicked out as early as possible. The chances of an early redemption decrease with time."

The return score for the notes is 7.16. It compares favorably with 6.67, which is the average return score for the product category. It also exceeds the 6.55 average of all products.

"It's a good return score, which indicates a high probability to get called early," she said.

"It's probably linked to the high correlation between the two funds, as the higher correlation lowers the risk.

"The high score reflects less risk than average, which gives you a good return if you do kick out.

"These product types are so complex: you've got the underlying, the threshold for the call, the amount of premium and the observation periods which could be weekly, monthly, quarterly, semiannually or annually. There are so many moving parts. You have to weigh out all these factors compared to the score of the same product type, and it gives you an above-return average score."

Price, overall scores

Future Value Consultants measures a note's value to the investor on a scale of zero to 10 via its price score. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

At 7.74, the price score of the notes is "much better" than the average of the same product type, which is 5.31, she said. The score is also higher when compared to all products, whose average price score is 6.75.

"It's very good," she said.

"I think it's probably because there's a good chance of kick out and the return is quite generous.

"However, we should keep in mind that the call premium is announced in a range. If they settle on the lower end of the range, the price score will likely come down. But it compares favorably in relation to similar products, at least with the hypothetical call premium that we used."

To run its analysis, Future Value Consultants use a value 25% lower than the upper end of the range. Based on this product's 10.4% to 12.4% range, the hypothetical call premium was 11.9%.

Future Value Consultants offers its opinion on the quality of a deal with its overall score. The score is simply the average of the price score and the return score.

The notes, with an overall score of 7.45, exceed in quality their peers, which show an average overall score of 5.99. The product is also ahead of the general average overall score of 6.65.

"The overall score stands out especially compared to the same product type," she said.

"This is probably because you have two correlated assets. It's a lower-risk version in the worst of/kick out category of products, and the correlation is good. It all comes together to give you a very good overall score."

Barclays is the agent.

The notes will price on Monday and settle on Thursday.

The Cusip number is 06741TNM5.

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