Barclays’ digital notes linked to S&P, Russell 2000 fit range-bound view with worst-of twist

By Emma Trincal

New York, Sept. 17 – Barclays Bank plc’s 0% digital notes due Sept. 29, 2015 linked to the lower return of the S&P 500 index and the Russell 2000 index are designed for investors who have a sideways view of the market, sellside sources said.

The sources added that the structure has a specific purpose: to allow investors to make money even in a down market as long as the decline stays within a range.

If the final index level of the lesser-performing index is greater than or equal to its barrier level, 85% of its initial level, the payout at maturity will be par plus the 7% digital percentage, according to a 424B2 filing with the Securities and Exchange Commission.

If the lesser-performing index finishes below its 85% barrier level, investors will be fully exposed to the decline of that index from its initial level.

“The best thing about that trade is the term. It’s a one-year,” a sellsider said.

Short range accrual

This sellsider added that the structure is a variation of a range accrual, comparing it to another product.

“We’ve seen something very similar, a 10-year note linked to the Russell 2000 and the Euro Stoxx, which I would categorize, just like this digital, as a range accrual. You were getting 7% per annum paid quarterly as long as the worst-performing index had not declined by more than 45%, so they gave you a 55% coupon barrier. The principal at maturity was protected by a 50% barrier. If the worst index dropped by more than 50%, you lost the protection and you were long the worst of the two,” he said.

The Barclays deal “is very similar” only it’s a “shorter version of it,” he said.

“Conceptually, I would call these deals range accrual because the coupons get paid based on the performance of the underlier and it has to stay within a range.

“A range accrual doesn’t have to accrue daily. It can accrue monthly, quarterly or, in this case, annually. What’s important is that you don’t participate in the upside. Your only upside is the coupon if the underlying index trades within the preset range.”

The fact that the Barclays notes are linked to two reference assets using a worst-of payout does not change the essence of the structure, he said.

Worst-of structure

“You can apply a worst-of feature to any structure. You can use it with a principal-protected note. If the worst index is down at maturity, you only get your principal. If both are up, you get the positive return of the worst one,” he said.

“With this deal, if the worst performer is above the barrier, you get your principal back and you get your coupon. If it’s not, you get no coupon and you get the downside exposure.

“It’s a range accrual because there’s one observation for your coupon, at maturity, and the coupon barrier is 85%. It also happens to be the principal barrier.”

When the coupon payment or level is based on the underlying trading within certain boundaries, the notes are often designed for investors who expect a range-bound market themselves, this sellsider said.

Not absolute

“This note works for a particular view. If you think the upside for both indexes is limited and you don’t think there’s a lot of downside, let’s say if you see this trading between down 10% and up 10%, then it’s worth considering,” he said.

The structure has some similarities to an absolute return payout but only superficially, he said.

“One advantage of the notes is that if the worst index is down by up to 15%, you’ll get more than par. You’re going to get the 7% digital. In that way, it’s reminiscent of an absolute return, since you’re gaining something out of a negative return, but I wouldn’t characterize it that way. When you use an absolute return, it’s implied that the absolute return is the downside to the barrier. If the index is down 15%, this digital would only get you 7%, while you would get 15% with an absolute return,” he said.

The important aspect of the deal, he said, is that investors have a chance to outperform the index in a range anywhere between minus 15% and less than 7%.

Market down, coupon paid

Tom May, partner with Catley Lakeman Securities, said that the structure offers investors a positive outcome if the market trades up or down but within a range.

“We’ve seen a lot of those, especially in the U.K. You’re giving up the upside, and they’re giving you a chance to get a positive return,” he said.

“This one has a short tenor. What I’ve seen in the U.K. are longer-dated products with a coupon paid when the notes get called. It’s a coupon that gets paid no matter when it gets called. After a few years, your autocall trigger steps down.

“For instance, you get called at the end of the first year if the index is above 100 and you get an 8% coupon. If you’re not called, you go into year two with the same call trigger and a call premium of 16%; same thing on year three with a coupon of 24%.

“But starting year four, your call trigger drops to 90%, followed by 80% on the fifth year and 70% on the last year. Meanwhile, you’re still receiving the same call premium of 8% per annum, so it gives you 32% on year four, 40% on year five and 48% on year six.

“The six-year structure may be long, but it’s worth going long-term because they give you as many chances as possible to get your coupon.

“The Barclays product is different. It’s shorter. There is no autocall. But the concept behind the deal is the same – getting a positive return even if the index is down. It’s a similar idea. I think it’s a very good idea.”

Barclays is the agent.

The notes were expected to price Wednesday and will settle Monday.

The Cusip number is 06741JW70.

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