Barclays' 7%-8% notes linked to S&P, Russell offer risk that is relatively low for structure

By Emma Trincal

New York, June 14 - Barclays Bank plc's 7% to 8% autocallable yield notes due Dec. 26, 2014 linked to the S&P 500 index and the Russell 2000 index offer in a worst-of format less risk than average for the structure type given the high correlation between the two underlying indexes, said Suzi Hampson, structured products analyst at Future Value Consultants.

Interest will be payable monthly.

The notes will be called automatically at par plus accrued interest if the indexes close above their initial levels on any quarterly observation date, according to an FWP filing with the Securities and Exchange Commission.

A knock-in event occurs if either index closes below its knock-in barrier, 75% of its initial level, on any trading day during the life of the notes.

If a knock-in event does not occur or if it does occur and the return of the lesser performing index is zero or positive, investors will receive par at maturity. Otherwise, investors will be fully exposed to the decline of the lesser performing index.

The notes deliver a "worst-of" payout: the call trigger and the breaching of the barrier do not depend on one index but on multiple underlyings, she explained.

"We see a lot of autocallable products. The worst-of is just a way to generate headline return over the term," she said.

"It's definitely a riskier version of the structure, which is why you get the higher yield.

"Rather than being limited to one underlying, your return is linked to the worst of two, or more. Worst-of notes are quite common; it's still a version of the autocallable reverse convertible but one that's much more complex."

Correlation

For the investor, assessing the risk generated by two different underlyings can be challenging, she noted.

"First you need to have a view on each of those underlyings; but you also have to estimate which one of the two is going to be worse," she said.

"The correlation risk is hard to quantify. With this product, the two underlyings are both U.S. equity indexes. It's a good thing in terms of risk reduction. Those two indexes are quite correlated. The one-year correlation between the S&P and the Russell 2000 is 90%. It's high. It helps as far as risk goes.

"The risk in a worst-of becomes really blurry when you have two non-correlated underlyings, for instance the S&P and the iShares Emerging Markets."

Investing in these products requires educating investors, she added.

"One of investors' common mistakes is to focus on the S&P only and not on all reference assets, ignoring that the return is not based on one index but on the riskier. This is not as if you were looking at an average. It doesn't matter what the S&P does. You are looking at two independent underlyings, not a combination of the two. It's not as if a less volatile index would absorb the volatility of the other. It doesn't work that way," she said.

"The more correlation there is between the independent underlying indexes, the more likely they are to move together. On the other hand, when there is little or no correlation, one is more likely to go down when the other goes up. The low correlation increases the odds of hitting the barrier.

"One of the attractive aspects of this particular product is the high correlation that you have between the S&P and the Russell 2000. It offsets some of the added risk that you get once you use this particular structure."

Investors in this product seek a higher income or a specific target return, she said.

"Your return is limited to the income that you get. There is no participation in the upside in any of the indexes," she said.

"This product is a reverse convertible with an autocallable feature. It pays a fixed interest rate. The longer you stay, the more income you get above the risk-free rate.

"Investors, however, are looking for the autocall to kick in because with the early redemption, you get your principal back. It eliminates the risk altogether."

Future Value Consultants assesses risk, return and price using a variety of proprietary scores in order to compare a product with others.

The research firm compares each product with two different averages: same product type and all recently issued products.

The Barclays notes belong to a product type called review reverse convertibles, according to Future Value Consultants' methodology. Those products pay a fixed interest rate and may be called automatically when the underlying is above a specific threshold. The proportion of "worst-of" notes in this category is relatively high, she noted.

Riskmap

Future Value Consultants rates the risk associated with a product on a scale of zero to 10 with its riskmap. The higher the riskmap, the higher the risk of the product. The riskmap is the sum of two risk components: market risk and credit risk.

"The risk map is relatively lower than the average of the same product type, but it's not due to the credit risk, which is greater. It's due to the relatively low market risk," she said.

The notes have a 3.36 riskmap, compared with an average of 3.60 for the same product type.

The credit riskmap is 0.52.

"This credit riskmap is high for an autocall," she said.

Generally, autocallables, which are short-term or likely to have a short expected duration, don't have a very high credit riskmap compared to the average of all products, she said, pointing to the 0.50 credit riskmap for the current general average.

The credit riskmap, however, is much higher than the 0.34 average for the same product type, she added. Hampson attributed the difference to the 18-month term, which is longer than the average autocallable reverse convertible.

The product showed a lower market risk than its peers based on its 2.84 market riskmap versus 3.26 for similar notes. This result could be due to a variety of factors, she said, citing the "probably more generous 75% barrier" and the high correlation between the two underlying indexes.

Risk-adjusted return

Future Value Consultants measures the risk-adjusted return with its return score on a scale of zero to 10.

"Interestingly, we get the same numbers. The notes score 6.33 for the return, the price and the overall score. In all rating categories, the notes offer superior scores than the same product type," she said.

For instance, the average return score for review reverse convertibles is only 6.12. The average price score for the category is 5.82.

"The return score is above average. This score reflects the risk-adjusted return of a product," she said.

"The worst-of, as a structure, is designed to bump up the coupon. It comes with additional risk.

"But by using the Russell along with the S&P rather than an uncorrelated fund, you're keeping the risk down.

"The high return score probably indicates that you're getting enough coupon for the lower risk that you are taking.

"It's always a decision for the adviser or the investor to take. Once you've decided that you want to limit your risk to a certain point, you have to decide what type of return may be acceptable to you. This return score suggests that you're getting a return that's above average for this kind of product given the risk you're taking."

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.

"Correlation risk is hard to pin down. Therefore the pricing of these deals is a little bit more difficult to measure as it's not easy to break down the price of the different options," she said.

"But this score suggests that investors have received good value.

"If the average price score for that structure type is particularly low, it's because it's harder for the issuer to hedge the options in a worst-of. Taking into account this factor, the notes display a remarkably good price score versus comparable products."

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 6.33 overall score compares favorably to the average score for that product type, which is 5.97, she said.

"Investors get a product which has less risk and a better overall score than its peers. That's what they want. In general, investors want as little risk as possible and as much return as they can. This note, compared to the same product type, is appealing for investors interested in capturing an attractive yield as long as they understand the risks associated with correlation," she said.

The notes (Cusip: 06741TWS2) are expected to price June 21.

Barclays is the agent.

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