Wells Fargo’s leveraged notes linked to S&P 500 Value offer access to bargain-hunting style

By Emma Trincal

New York, Aug. 13 – Wells Fargo Finance LLC’s 0% market-linked leveraged securities due Aug. 23, 2024 linked to the S&P 500 Value index give investors access to a pure value play, a contrarian strategy given how value has underperformed growth over the past decade, advisers said.

The payout at maturity will be par plus 125% of any gain in the index, capped at par plus 70% to 75%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will lose 1% for each 1% decline in the index beyond a 15% buffer.

“Do you think value is due to make a comeback? That’s the whole idea behind this note,” said Tom Balcom, founder of 1650 Wealth Management.

“Whether the structure is the best to make that kind of a bet is another matter,” he added.

Occasional index

The use of the underlying index, which was launched in 1992, has never been widespread in the structured notes space.

This year for instance, the S&P 500 Value index has been the underlying for only two offerings, according to data compiled by Prospect News. Both were five-year leveraged buffered capped notes, similar to this one. The first one, also from Wells Fargo, priced in April for $5.1 million. The other, back in May, was brought to market by Morgan Stanley Finance LLC in a $4.1 million deal.

S&P Dow Jones Indices extracts value picks from the S&P 500 index to constitute is S&P 500 Value segment, using three fundamental ratios: book value to price, earnings to price and sales to price.

Unlike growth investors who select stocks that have a high potential for capital appreciation but may be expensive, value investors pick stocks that trade below their fundamental value. Their prices, however, may not change as rapidly, and their volatility tends to be lower.

The top three holdings in the S&P 500 Value index are Apple Inc., JPMorgan Chase & Co. and AT&T Inc.

Lagging performer

“It’s some sort of contrarian bet to invest in value stocks because their performance has been lagging the overall market and also growth,” said Balcom.

Over the past five years, the annual total return of the S&P 500 Value index has averaged 8.47% versus 13.44% for the S&P 500 Growth index, according to iShares, which runs two exchange-traded funds that replicate the performance of each index.

The S&P 500 Value ETF is up 19.35% year to date, outpacing the S&P 500 Value ETF by more than five percentage points.

A bet on rates

Balcom would be cautious about investing in the underlying index and therefore also in the notes. He pointed to two sectors that are sensitive to interest rates and whose combined weighting is more than 28% of the portfolio.

“If you’re bullish on financials and energy, this will make sense. If you believe that interest rates will eventually rise, it’s a good play. I’m not too sure that that’s the case. If interest rates continue to go down, I wouldn’t be bullish on those two sectors. Five years is a long time to make that call,” he said.

Buffer, leverage

Balcom had another concern: the downside protection.

“While it’s good to have a buffer, I don’t know if 15% is enough,” he said.

Investors in the notes have to give up about 2.25% in dividend yield, he noted, or approximately 11% for the period.

“Even if 15% is enough, they’re not giving you much more than the dividends. Your 15% buffer is basically an extra 4% on top of the dividends.”

On the other hand, the 70% to 75% cap was “reasonable,” according to Balcom. It represents 11.2% to 11.8% in annualized compounded return.

But the cap may not be so easy to reach. With the 1.25 leverage factor the index would need to rise between 9.3% and 9.85% a year to hit the 70% to 75% cap bracket.

“This doesn’t blow my hair back here,” he said.

“I don’t know if I would participate in the note. The buffer isn’t that great all things considered. The cap isn’t bad, but the leverage factor is so low.

“I’d want a higher leverage and a bigger buffer.”

Upside potential

Steven Foldes, vice-chairman of Evensky & Katz/Foldes Financial Wealth Management, found the underlying strategy interesting. But for reasons different from those expressed by Balcom, he objected to the structure as well.

“Value is an interesting strategy,” he said.

“The last 10 years have shown a better run for growth stocks, which may be a reason to switch to value investing at this point.

“We do have a bias for value following the philosophy of DFA funds, which are using that bias to their advantage: value over growth and also small cap over large cap,” he said.

Dimensional Fund Advisors (DFA) is a fund manager that uses academic research to generate alpha.

Cap is a no-go

“We have no problem investing in value stocks given the underperformance. We think the S&P 500 Value index has the potential to rise. But if we’re going to own it, we want to get the full measure of the return and not be capped,” he said.

“In general, I certainly don’t like having a cap, particularly a modest cap over a five-year period.

“It may be a fine return based on historical norms. But it’s not going to let you participate in a substantial rally.

“The leverage is nice. But the cap is not acceptable.”

Dividends

The tenor was another negative.

“I have no problem with the issuer’s credit. Wells Fargo has a very good credit, perhaps the best among its peers,” he said.

Indeed, at 47 basis points, Wells Fargo’s five-year credit default swap rates are the second tightest among big U.S. banks just after JP Morgan (45 bps), according to Markit.

“The problem with this long duration is the amount of dividend I’m giving up over a long period of time.

“It’s 2.25% a year for five years. That’s expensive. This dividend is higher than the S&P.”

The S&P 500 index yields 1.85%.

In addition, Foldes tends to buy shorter notes as a general rule. A two- to three-year tenor would be his maximum duration.

Buffer

Even if he did buy a five-year note, Foldes said the amount of buffered protection could have been better used elsewhere.

“While having a hard buffer on a short-term note makes sense, it’s unnecessary and expensive on a five-year. The likelihood of being negative over a five-year period is so small, you’re not making the most of the structure,” he said.

“The 15% buffer is not necessary from my perspective.”

In order to invest in this index through a structured note, Foldes would have to reconfigure the structure.

“I would need it to be shorter, and I would want a greater upside and possibly more leverage,” he said.

“If I’m going to go five-year, assuming I would buy that duration in the first place, I don’t want a cap and I don’t have a use for a buffer.”

The notes are guaranteed by Wells Fargo & Co.

Wells Fargo Securities, LLC is the agent.

The notes will price on Friday.

The Cusip number is 95001HA35.

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