Barclays’ worst-of notes on S&P 500, MidCap 400 offer good terms, but buffer may be hard sell

By Emma Trincal

New York, July 21 – Barclays Bank plc’s 0% Super Track notes due Jan. 26, 2017 linked to the lesser performing of the S&P 500 index and the S&P MidCap 400 index offer attractive terms, said a financial adviser, but a distributor said the leveraged buffer on the downside may make the product harder to sell, especially to retail investors.

If the return of the lesser performing index is positive, the payout at maturity will be par plus 150% of the return of the lesser performing index, according to a 424B2 filing with the Securities and Exchange Commission.

If the return of the lesser performing index is between zero and negative 15%, the payout will be par. If the return of the lesser performing index is less than negative 15%, investors will lose 1.17647% for every 1% that it declines beyond 15%.

Nearly one index

Carl Kunhardt, wealth adviser at Quest Capital Management, said that although worst-of structures such as this one are not always well perceived by clients, they can “make sense” if the underlying indexes are sufficiently correlated. A payout linked to the lesser performing index also offers pricing advantages, usually making the risk-adjusted return more attractive to the investor.

“I like it. It’s a nice little note. The two indexes move so closely, they’re so correlated, they might as well be the same index,” Kunhardt said.

The S&P 500 includes 500 leading companies and captures about 80% of the large-cap space, which represents companies with a market capitalization of more than $5.3 billion, according to Standard & Poor’s website.

The S&P MidCap 400 tracks the stock price movement of 400 companies with mid-sized market capitalizations ranging from $1 billion to $4.4 billion.

“The mid-cap category is a hybrid group of companies that are too big to fit neatly into the small-cap [category] but [are] in reality still large enough to hit that large capitalization sphere,” Kunhardt said.

“The correlation on the S&P 500 especially with mid-caps is fairly big.

“That’s why the worst-of doesn’t bug me at all because they are going to perform fairly similarly.

“You’ll get more volatility on the mid-caps, and hopefully this will give you a little bit more of upside capture.

“You may also get, unfortunately, more downside risk. So the worst of is likely going to be the mid-cap index because in most markets, the mid-cap is going to be the one with the lower return, except in a raging bull market, in which case it doesn’t matter much. You’ll just lose a little bit of the upside.”

Attractive terms

Not many worst-of deals offer unlimited and leveraged upside with a buffer, he said, adding that the structure, as a result of this, is appealing.

“I like the leverage part with the no cap, particularly if you’re going to be capturing more volatility,” he said.

“I like the buffer. They’re still giving you a true buffer, not a barrier. I’m willing to take a look at this because you’re mitigating the losses. I usually don’t like leverage on the downside, but if you’re factoring in the first 15% buffer, you’re still ahead of the game.”

He offered an example: a 20% decline in the worst performing index would translate into a 5.9% loss for the investor as opposed to a 5% loss with a standard 15% buffer.

“It’s a slightly higher loss, but it’s still good,” he said.

“Finally, they can structure all this on a two-and-a-half-year [note], which is relatively short. Barclays is a good credit. We’re very, very comfortable with this issuer.

“Unless there is something else on the prospectus that would be fundamentally wrong, I think this is quite enticing.

“Sometimes the fee is the negative surprise.”

But with the fee at 75 basis points, according to the prospectus, the terms of the deal, overall, were quite good, he said.

Worst-of and correlation

Worst-of structures are not always popular structurers among clients because of the fact that returns are linked to the lowest performance, he said.

The adviser should assess the value of such notes by looking at the correlation of the underliers first, he said.

“A worst-of is not necessarily a bad structure as long as it makes sense,” he said.

“If you had given me the S&P 500 with the MSCI Emerging Markets, I would have said, ‘Oh, wait a minute ... these are on totally opposite ends.’ But large and mid-cap is a different story. Under some systems, there is not even a mid-cap category. Value Line for instance has either small or large cap in addition to value and growth.

“A lot of people think that mid-cap stocks represent a made-up asset class, and when you look at the correlations, they kind of are.

“As a company starts being bigger, it gets expanded coverage, and so the number of categories expands too. They’ve created the mid-cap category. Some have expanded even more, introducing the micro-caps, which are smaller than the small-caps, or the mega-caps, bigger than the large-caps.”

Because the S&P 500 index is designed to provide a performance benchmark for the U.S. equity market as a whole, the mid-cap index is likely to move in the same direction, he said.

“I think the correlation between large- and mid-caps will be a plus in this note,” he noted.

“It’s not as if you would have one index up 20% and the other down 20%. It’s more like it’s going to be 17% up and 20% up. Which one will be the worst of the two? It depends on what the market condition is. But you’re not going to find a huge gap between the two. That’s the good part.”

Geared buffers: a tough sale

A distributor specializing in retail distribution said the worst-of structure may not be the most difficult aspect of the deal in terms of explaining it to investors. Far less understood would be the geared buffer.

“A 15% buffer is a nice protection, but for downward gearing, they may demand more of the hard buffer, at least if you’re dealing with retail ... they may ask for more,” this distributor said.

“Institutional investors are a different animal. They may prefer a larger amount of protection even if it’s a barrier instead of a buffer. They would be willing to get the contingent barrier option European style for more than 15%, perhaps an 80% barrier or lower.

“Even though the gearing on the downside is minuscule, it’s something clients, especially retail clients, are not used to. That’s my two cents.”

Simplicity first

“It’s more of an issue of complexity than risk,” he said. “Even if the buffer has value, there are plenty of protections out there. Chances are they’ll go for something a little bit more plain vanilla.

“Advisers also stay away from complexity, and the gearing is somewhat complex. They’d rather not have to explain it. Even if 15% is nice, they’ll shun this type of protection for something more straightforward.”

But the distributor noted that offerings brought to market are not just the result of what investors want. They are also a result of market and pricing conditions.

“This avoidance of geared buffers will change if plain vanilla becomes increasingly more expensive, and we may be heading in that direction. But for now, advisers and investors alike prefer simplicity,” he said.

This view reflects the types of clients this distributor caters to.

“We do merely retail. We do have some high net worth, but our bread and butter is regular mom and pop,” he said.

“The perspective could be very different from the [registered investment adviser] space. Perhaps in this market, the downside gearing is seen as a plus as it enhances the terms. But for us, we’d rather focus on simplicity first. We do equity delta one tied to an enhanced equity strategy for the most part, things that are easy to grasp.”

Barclays is the agent.

The notes were scheduled to price Monday and settle Thursday.

The Cusip number is 06741UGH1.

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