Barclays’ notes tied to Barclays Trailblazer Sectors 5 offer good option if index makes sense

By Emma Trincal

New York, Jan. 9 – Barclays Bank plc’s 0% notes due Jan. 31, 2022 linked to the Barclays Trailblazer Sectors 5 index offer many structural advantages, but buysiders are not always inclined to seek exposure to proprietary indexes often seen as lacking transparency, according to buysiders.

The payout of the notes at maturity will be par plus triple any index gain, according to a 424B2 filing with the Securities and Exchange Commission.

If the index falls or remains flat, the payout will be par.

Proprietary index

“I might do this but in a limited amount, and I would probably start with my own portfolio,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

“The reality is, I like the notes. But I never liked proprietary indexes.

“My investment is not in the notes. My investment is in the index.”

The Barclays Trailblazer Sectors 5 index is a rules-based proprietary index created and owned by Barclays Bank plc, according to the prospectus.

The index tracks a dynamic notional portfolio selected from a universe of 13 exchange-traded funds that provide exposure to U.S. equity sectors or fixed-income assets while targeting a portfolio volatility of 5%. The strategy is based on modern portfolio theory and seeks to achieve an optimized risk-adjusted return.

“I like the notes. What’s not to like about three times leverage when it only applies to the upside? And who doesn’t want full principal protection?” said Kunhardt.

“But you also have to understand where the return is coming from.

“Three times leverage, no cap is great but three-times zero is still zero.”

Objections

Kunhardt said he had two objections. The first one was the credit risk exposure over a five-year investment term. The second was related to the underlying index.

“The problem with a prop index is that it’s difficult to understand,” he said.

“They don’t tell you why they select a fund versus another.

“It’s based on modern portfolio theory. That’s an absolutely solid theory in academics. In the real world, it almost never works.”

Magic box

A buysider said that proprietary index-based notes were a mystery to him. This product was no exception.

“It’s just not logical that it would even exist. Who wouldn’t want to get three times the return of an index with no cap and full downside protection? It seems too good to be true.

“In fact, I’m not sure I understand how the bank can even make money on it.”

A sellsider explained that it could. In addition, proprietary indexes with volatility targets allowed issuers to offer better terms to investors.

Investors in the notes buy a zero-coupon bond in order to obtain the full downside protection. They also give up five years’ worth of interest. In exchange, they can buy the call options for the leveraged participation. Enough money is left in the deal for the issuer’s fee, this sellsider said.

One of the reasons the cost of the options is cheaper is because the volatility of the underlying index is controlled. In fact, the volatility target is designed for this effect, he said.

The lower cost in turn allows the issuer to provide enough leverage while being able to still make a profit.

Protection and volatility

One downside of the strategy for investors may be to overpay for the protection.

“Your investment moves much less than the market even with three-times leverage. If you’re going to have principal protection would you rather have it with something that moves a lot like the S&P or with something like that, which doesn’t move much?”

The volatility control mechanism sometimes requires the sale of the risky assets and their replacement by assets generating muted returns or even cash.

But Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, said that even with less volatility, the high leverage factor was still valuable.

“If somebody is looking for a low-volatility-type of investment, this would certainly make sense,” he said.

“If the market goes up, it’s certainly a more conservative way to play it. You’re getting the leverage. It makes up for the low volatility. All you’re losing is the income from the index and the opportunity cost for being tied up for five years, which in my opinion is a long time.

“But you have full protection if there’s a selloff. It’s not a bad strategy to consider.”

Barclays is the agent.

The notes (Cusip: 06741VG63) will price on Jan. 26 and settle on Jan. 31.

© 2015 Prospect News.
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