Barclays’ 95% principal protected notes tied to MSCI Europe show competitive pricing

By Emma Trincal

New York, July 31 – Barclays Bank plc’s 0% partial principal at risk securities due Sept. 3, 2020 linked to the MSCI Europe index offer terms that could never price on the S&P 500 index, a market participant said.

If the MSCI Europe index finishes at or above its initial level, the payout at maturity will be par plus at least 1.25 times the gain, according to a 424B2 filing with the Securities and Exchange Commission.

If the index falls by up to 5%, the payout will be par.

Otherwise, the payout will be par plus the return with a minimum payout of 95% of par.

Forwards

“It’s pretty plain-vanilla for a deal on a European benchmark,” the market participant said.

“Right now, all European benchmarks, good or bad, are pricing well. They’re not extremely volatile and the forwards are negative.”

The negative forwards means that the cost of buying the options is cheaper. Forwards are calculated from the interest rates and the dividend yield of the underlying equity asset. The lower the rates and the higher the dividend yield of the equity benchmark, the cheaper the forwards. Interest rates in Europe are much lower than in the U.S. where the monetary policy is on normalization mode, he explained. The yield on the 10-year German government bond is 0.45% compared to 2.96% for the 10-year U.S. Treasury.

Can’t do it here

In addition, the MSCI Europe index yields 3.68% versus 1.82% for the S&P 500 index.

“If you were trying to replicate this deal on the S&P, you wouldn’t be even close,” he said.

A U.S. version of the notes would not be possible unless done with less than a one-to-one participation if the upside had to remain uncapped.

“It would probably be 0.5 or 0.6 times the return of the index. Otherwise, you’d have to cap it, maybe at 15%,” he said.

“I’ve done three-year on the FTSE 100, full principal-protection, no cap,” he said.

“Those European notes are easy to price even with the full protection. But to tell you the truth, I’m sick of seeing so many of them.

“On the issuers’ calendars you see a lot more European deals than a normal allocation should be.

“People do it because it prices well.”

Vol. control

From a structuring standpoint, he said that volatility-controlled indexes offer similar pricing opportunities.

Volatility controlled indexes target a certain amount of volatility for the portfolio and reduce the risk by actively reallocating to risk-free assets when volatility nears its target.

The low volatility of those algorithmic indexes cheapens the cost of the options, making the leverage less expensive to implement, he said.

“They’re just a little bit more expensive because they reinvest the dividends. But I’m surprised at how close they price compared to the European ones,” he said.

Rebalancing portfolios

There is however a strategic reason behind U.S. investors’ drive to buy notes linked to European equity, he noted.

As the U.S. stock market is on track to hit its all-time high again (the S&P 500 index is 56 points away from its January peak) investors are trying to rebalance their portfolios by reducing their exposure to highly valued assets, especially tech stocks, he explained.

Twenty eight percent of the S&P 500 index is in technology stocks, he observed. European indexes have much lower weightings in comparison, such as 5.6% for the MSCI Europe index and 8.85% for the Euro Stoxx 50 index.

“There’s a lot more of industrials, consumer staples, consumer discretionary,” he said.

Broader index

One particularity of the notes was the use of a lesser-known European benchmark.

“The Euro Stoxx is a lot more popular,” he said.

And yet, the MSCI Europe index with 447 constituents versus 50 for the Euro Stoxx offers exposure to a wider universe of stocks. It also diversifies more broadly across 15 countries, some of which are not euro zone members. Together the U.K. and Switzerland for instance have a 42% weighting, making this index a candidate for investors looking to diversify away from the tail and geopolitical risks associated with the euro zone.

“I don’t know exactly why they use the Euro Stoxx so much more. Part of it may be a licensing thing,” he said.

Flat is bad

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, said that he liked the notes overall given the current market conditions.

“I do like the protection in the market we’re in. You can’t lose more than 5% and you’re getting 1.25 times the upside with no cap. That’s nice,” he said.

“I don’t love the fact that you’re not getting the dividends though.”

That’s because in a very flat market, the leverage factor may not be enough to offset the “loss” of dividends, generating the risk of underperforming the index, he explained.

“We’ve been up and down this year but we’re at equilibrium. The S&P is up only 2.5% so far,” he said.

In this range bound market, the cost of losing a dividend yield of 3.68% would be heavy, he noted.

Not bad at all

“So the downside in this one is the risk of a market trading sideways. Another downside to me is the two-year. In two years, the market could go up and then down and you’re kind of stuck. I’d rather have a one-year.”

However, Chisholm said those “negatives” were not insurmountable. The tradeoff for investors, in particular the quasi total protection against market losses, offset in many ways those disadvantages.

“Overall, I like this deal. I like the structure. It gives investors who want to invest in Europe that protection without capping the upside. It’s one of the better ones I’ve seen.”

Barclays is the agent. Morgan Stanley Wealth Management is the dealer.

The notes will price on Aug. 15.

The Cusip number is 06746T219.

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