Barclays trigger gears tied to the Dow to offer equity substitute, perform well in bull market

By Emma Trincal

New York, Jan. 12 – Barclays Bank plc’s 0% trigger gears due Jan. 31, 2023 linked to the Dow Jones industrial average equal weight index could appeal to bullish investors seeking an alternative to a direct investment in an exchange-traded fund tracking this index, said Tim Mortimer, managing director at Future Value Consultants.

The payout at maturity will be par of $10 plus 1.27 times to 1.37 times any index gain, with the exact participation rate to be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 25% and be fully exposed to any losses if the index finishes below its 75% downside threshold.

Tradeoff

“It’s a very easy to understand, plain-vanilla note,” Mortimer said.

“You get the upside in excess of a straight participation, and also, you have a downside barrier.

“The 25% contingent protection isn’t bad.

“It’s a product you may want to use as an alternative to the ETF.”

Two factors play in favor of the notes compared to owning the fund that tracks this index, he said.

“The first one is the participation; the second one is the barrier.”

On the other hand, some of the benefits of investing directly in the ETF are not available, which are not getting the dividends and having the credit risk exposure, he added.

“The upside leverage and the protection are there to compensate you for those two disadvantages.”

No cap

The longer maturity helps pay for the protection and the calls on the upside as more dividends are accumulated.

The Dow Jones industrial average yields approximately 2%. Over five years, investors incur an opportunity cost of 10%.

“The nonpayment of dividends provides additional funding, which is one of the ways the issuer is able to get rid of the cap. You would need a cap on a short-term maturity,” he said.

Excess return

Because the notes offer upside leverage and downside protection, they can outperform the underlying benchmark in certain market scenarios.

“This product will do best in a market that performs very strongly because at a certain point your leverage offsets the loss of dividends,” he said.

A 31% price return over the term represents the breakeven. “From that point on, it becomes more advantageous to own the notes without the dividends than being long the index,” he explained.

Investors given the size of the protection are likely to outperform on the downside as well unless the price decline is modest, in which case owning the dividends gives the advantage to the shareholders.

“You don’t want a sideways market. If the downside is very flat or if you’re not getting a very high return on the upside, this product would be uncompetitive compared to the ETF,” he said.

Scorecard

Future Value Consultants produces stress testing reports on structured notes intended to help its clients make a well-informed decision when purchasing products based on their specific market outlook and risk tolerance.

Each report provides information organized in 29 tests or tables. The model runs a Monte Carlo simulation based on several market scenarios as well as a back tested analysis over three different time horizons.

One major table is the investment scorecard. It shows all the possible and mutually exclusive outcomes of product performance with probability of occurrence and average payoffs for each.

This simple structure only has three possible outcomes: positive return when the index finishes above initial price; full capital return when there is neither loss or gains because the index declines but stays above the barrier; and capital loss below this barrier level.

Probabilities of losses, gains

“The odds of losing money with this product are not huge according to our simulation,” he said, commenting on the 18.97% probability of capital loss seen in a neutral scenario. When this happens however the average loss is about 48%.

“We know that with a barrier, once you breach, your losses are significant,” he said.

Investors are sure to lose at least 25% when the barrier is hit. The model shows an average loss twice this amount, he noted.

Mortimer then looked at the back tested analysis, focusing first on the past 15 years. He compared the findings with what the forward-looking simulation reveals.

The probability of the positive return outcome to occur is 60% with the simulation and 70% for the past 15 years of the back testing analysis.

Separately the average gains showed a wider gap between 35% from the model and 53% in the 15-year back testing report.

“It’s interesting. Over the past 15 years, the chances of getting a positive return were not that much higher than in our simulation. On the other hand, the average payout is much higher in the back testing.

“This suggests that in spite of the bad years of the financial crisis, this note has delivered some good returns,” he said.

Capital performance tests

The reports also include simulations for other market scenarios. Those are bull, bear, more volatile and less volatile. Each simulation per market scenario depends on an assumed growth rate for the underlying.

Future Value Consultants uses “reasonable” growth estimates for its model. For instance, the bull scenario for this report is based on a 5.8% annual return.

The capital performance tests present the various probabilities of occurrence and average payouts for each of those market scenarios.

In the case of the bull market for instance the probability of losing capital far lower than what it is in the neutral environment at 5.86% versus 18.97% respectively. Meanwhile the chances of positive return are much higher in the bull scenario at 81.86% than they are in the neutral at 57%.

“This is not surprising. The bull scenario is the ideal environment for this product,” he said.

He then compared average payoffs between the bull simulation and certain back testing periods.

When investors obtain a positive return, they may expect a 160.6% payout in the bull scenario, according to the simulation. This is nearly the same thing as what investors received on average over the past 10 years, which is 163.1%, according to the back testing analysis.

“That’s about in line with our simulation. The past 10 years have seen pretty steady growth,” he said.

Bullish bias

In conclusion, he said the notes gave investors with a bullish view an alternative to an ETF when seeking exposure to the U.S. market.

“This is for someone who is relatively bullish and wants a bit of protection,” he said.

“It has two sweet spots. You’ll do very well if the index is up a lot or declines moderately.

“You’re not getting the dividends and you’re taking on the credit risk for five years.

“But you’re getting compensated for that unless the market is flat and goes nowhere.”

Barclays and UBS Financial Services Inc. are the agents.

The notes will price on Jan. 26 and settle on Jan. 31.

The Cusip number is 06746P696.

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