BNP’s certificate plus notes tied to S&P 500, EAFE and EM ETFs aimed at cautious investors

By Emma Trincal

New York, July 7 – BNP Paribas’ 0% leveraged certificate plus notes due July 31, 2020 linked to the S&P 500 index, the iShares MSCI EAFE exchange-traded fund and the iShares MSCI Emerging Markets exchange-traded fund are designed for skittish investors who primarily value a defensive barrier, buysiders said.

The S&P 500 will have a 53% weight, the MSCI EAFE ETF a 42% weight and the MSCI Emerging Markets ETF a 5% weight, according to a term sheet.

If the final basket level is greater than or equal to the initial level, the payout at maturity will be par plus 100% to 120% of the basket return, with the exact participation rate to be set at pricing.

Investors will receive par if the basket falls by up to 50% and will be fully exposed to any basket decline if it drops beyond the 50% barrier.

Headlines

“This is a note based on recent headlines. It’s for people who worry about China and Greece. It’s designed to appease these types of investors with a pretty big barrier,” said Tom Balcom, founder of 1650 Wealth Management.

“Some clients get scared in this environment. They want exposure to the market but they also want to reduce risk as much as possible. For an adviser, this is an opportunity to show them something that may make sense for them. They get market exposure for five years with this 50% barrier.”

Diversified portfolio

The barrier was not the only element used to attract conservative investors. The asset mix offered diversification.

“Your greatest exposure is in the S&P 500. Emerging markets, the most volatile of the three basket components is limited to 5%. Within the emerging markets ETF, China represents a quarter of the ETF. So you really have only a little bit more than 1% in China. It’s negligible,” he said.

Even the EAFE fund, which tracks developed markets, offered some diversification away from a Europe currently in crisis with exposure to other parts of the world. In Europe, the emphasis was on the strongest economies of the euro zone.

“The exposure to the Southern European countries – Greece, Italy, Spain and Portugal – is very small. Greece is a tiny 0.70% of the index. Spain is only 3.45%, and Italy is just 2.30%,” he noted.

Almost 60% of the index is in four countries – Japan, the U.K., Switzerland and Australia – which are not part of the euro zone. In the euro zone, the stronger nations get represented the most such as France, which makes for 9.67% of the index and Germany at 9.10%.

“The basket allows investors to diversify away from current headline risk. They have an allocation mostly to the U.S. and large developed countries. Their exposure to riskier areas such as emerging markets and the euro zone is limited,” he added.

“You have this carefully selected basket of equity, an incredible protection and the no-cap. These are definitely good features.”

Leverage, dividends

But the tradeoff for that was: “missing out” on dividends over a five-year period, he noted. In addition, the participation rate, which will be anywhere between 100% and 120%, remains unknown.

“There may not be any leverage at all on the upside. Hopefully it will move toward 120 rather than 100. You need enough leverage to at least compensate you for not receiving dividends,” he said.

For a certain type of client, the note could be useful.

“We haven’t used it. But it’s a good tool for an adviser who wants to help a client get away from cash and go back to the market. If the client really wants protection it makes sense,” he said.

“The price for this protection is no dividends over the course of five years.

“I would want the leverage and enough of it in order to compensate me for that.

“It may not require that much more. Over the past five years, the annualized return of the S&P 500 index was 14.89% for the price index and 17.34% for the total return index. You’re talking of a 2.45% difference. Leverage should be able to take care of that. It will be interesting to see what they come up with at pricing.”

Donald McCoy, financial adviser at Planners Financial Services, also looked at unpaid dividends, a factor that becomes more relevant when the notes have a longer duration than average and when the basket components’ yields are high.

Tradeoff

“You’re giving up approximately 2% dividend each year,” he said.

The dividend yields for the S&P 500 index, the EAFE ETF and the emerging markets fund are respectively 1.96%, 2.67% and 2.09%.

“If you accept that valuations are at best at fair value if not stretched thin, the types of returns you’re going to get in a low return environment... a lot of those returns are going to come from dividends rather than capital gains.

“You undercut your returns. What you’re balancing that against is you’ve got that protection.”

Investors’ outlook determined whether the tradeoff made sense or not, he explained.

“In a sense you’re preparing yourself for a worst-case scenario. It really is an investment driven by fear,” he said.

“If you had reasonable return expectations you would make a straight investment in the basket and move on.

“This is for people who are pretty bearish.”

Almost bearish

The real incentive to buy the notes was on the downside, not the upside, he added.

“On the upside, you’re pretty much giving up the leverage. Even if they end up giving you 1.2 times, it may only give you back the dividends. It’s not a leverage play.”

He offered some examples based on the maximum leverage multiple of 1.2.

If the price return of the basket finished up 5% after five years, investors in the notes would only receive 6% versus 15% for a long-only equivalent investment that includes 10% worth of dividends over the term.

The price return of the basket would have to be over 50% to enable the noteholders who do not receive dividends to outperform a straight investment in the basket.

“The incentive to invest is much more on the downside,” he said.

Any price decline in the basket of less than 50% would completely protect investors’ principal, which is not the case with a long-only position in the basket despite a 10% cushion in dividends.

“This is for people who are really concerned about the market. If you have a halfway optimistic outlook this would not be the product for you,” he said.

“For me this would be for the very conservative clients who are just at this point terrified about significant market disruptions.”

The Cusip is 05579TFG6.

BNP Paribas is the agent.

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