Bullish investors should focus on cap when buying buffered leveraged notes: analyst

By Emma Trincal

New York, Dec. 24 - Investors who are bullish on a reference asset and who are trying to choose between two identical structures both capped and leveraged should pay close attention to the cap, said structured products analyst Suzi Hampson at Future Value Consultants.

Hampson compared two buffered enhanced notes both linked to the iShares MSCI EAFE index fund. Besides a slight difference in maturities - one of the notes has a two-year term; the other is 18 months - what set apart the two products were their differences in participation rates and their respective caps.

Hampson analyzed both products following her firm's methodology based on risk, value and return parameters. She concluded that, "For those structured product, if you have a bullish view on the underlying, you wouldn't want to be capped or at least, you would want to keep your cap to a minimum."

Her comparative example even suggested that for bullish investors, the cap was more significant than the amount of leverage applied to the notes.

Barclays Bank plc represented the first deal - a planned offering of zero-coupon buffered SuperTrack Notes due June 30, 2011 and also linked to the iShares MSCI EAFE index fund.

The payout at maturity will be par plus triple any fund gain, up to a maximum return of 9.3% to 12.5%. The exact cap will be set at pricing.

Investors will receive par if the fund shares fall by up to 15% and will lose 1% for each 1% drop beyond 15%.

The second deal was from JPMorgan Chase & Co. This issuer plans to price 0% buffered return enhanced notes due Dec. 30, 2011 linked to the iShares MSCI EAFE index fund.

The payout at maturity will be par plus double any increase in the exchange-traded fund's share price, subject to a maximum return of 24.5% to 29.5% that will be set at pricing. Investors will receive par if the share price declines by 15% or less and will lose 1% for every 1% that it declines beyond 15%.

In summary, the Barclays structure is shorter in term. It offers three times leverage but its cap is lower.

On the other hand, the JPMorgan notes have a slightly longer tenor. The product has a higher cap but its leverage is only two times.

Caps explained

Hampson began her comparison by analyzing the factors explaining why one transaction had a cap higher than the other and whether it "made sense."

She said that all maturities being equal, the product with the lower gearing should have the higher cap.

The JPMorgan notes have a lower participation rate and a higher cap. "That's fine. This is what you have here," she said.

In addition, maturities were also an important driver for setting up a cap. The longer-dated deal from JPMorgan had the highest cap. "It's a two-year. The longer the maturity, the higher the cap; so, this makes sense too," Hampson noted.

She added that, "When comparing two products with different caps and gearing, the product with the highest cap is normally the one with the longer maturity and the lower gearing."

Risk variables

Hampson then compared the two products based on risk. She used riskmap - a Future Value Consultants' rating that measures the risk associated with a product on a scale from zero to 10.

Barclays' notes had a 6.18 riskmap versus 6.96 for the JPMorgan product. The determining factor was the term of each deal, she said.

"The 15% buffer is exactly the same for both deals," said Hampson. "Because of that, you would expect a fairly similar riskmap, which we've got. The deal with a longer maturity [in this case JPMorgan] has a slightly higher riskmap, which is normal. The longer the term, the greater the risk."

Return potential

The same factor - the difference in maturity - partly explained the difference in return potential as evaluated by Future Value Consultants' return rating. This indicator measures, on a scale of zero to 10, the risk-adjusted return of the notes.

The return rating of the two-year notes is somewhat higher: 4.80 versus 4.04. It's because of the higher cap.

"The longer-dated deal also has the highest return potential," said Hampson.

But the cap was a much more significant factor, said Hampson. JPMorgan scored the highest return rating because its cap was higher than the maximum return of the Barclays product, she noted.

Return probabilities

Hampson introduced another variable in her comparative analysis of the returns. She looked at her firm's return probability table, focusing on what was for each deal the probability rate of reaching a return comprised between 10% and 15%.

She found that the notes with the highest return ratings did not necessarily offered the highest probability to earn the top return. In fact, it was exactly the opposite.

The JPMorgan notes with the highest cap and the lowest gear showed the lowest probability of reaching the 10% to 15% return range. That probability was 48%. In comparison, the Barclays investment had a 51.5% probability to hit such range of return.

"In this case, it's not the cap that makes a difference but the gearing," said Hampson. "The two-year, because it only has a 200% gearing scores a lower probability of hitting the highest return."

Bull dynamic

From this return analysis, Hampson drew a conclusion: Investors must carefully take into account not only leverage and cap, but their own view on the underlying stock, basket of securities or index.

"The product with the lowest cap gives you a lower return parameter. However, in this example, the same product also gives you a higher probability of getting a top return because you have more leverage. It means that you need the index to move less to get your maximum return," Hampson said.

"If you're bullish on the index and think it has the potential to move higher, you might prefer the JPMorgan product with the lower participation rate but the higher cap. You just need to assume that the market will move up sufficiently to allow you to get your maximum return which compared to the other note is a much higher return," she said.

Overall rating

Hampson concluded her analysis looking at other indicators before establishing the overall rating.

One of those factors is value. The value rating on a scale of zero to 10 is Future Value Consultants' measure of how much money the issuer spent directly on the assets versus fees and profit margin. The JPMorgan notes had a higher value score - 9.78 - than the 8.91 score seen for the other deal.

"It simply means that we think that this issuer has paid more on the assets on an annualized basis. We think they're taking less payout per year. So the JPMorgan deal has more value for the investor," Hampson said.

Hampson then looked at the simplicity ratings, which are based on the product type and measure on a scale of zero to 10 the transparency of a structure.

"Here, the two structures are exactly the same," said Hampson, explaining why both deals had the same simplicity rating of 8.50.

In conclusion, Hampson compared the two overall ratings, which assess on a scale of zero to 10 Future Value Consultants' opinion on the quality of a note.

The overall rating combines component scores, weighted 40% to the value rating, 40% to the return rating and 20% to the simplicity rating.

The JPMorgan deal had an overall rating of 7.53. The Barclays notes scored 6.88.

Hampson said that the result was easily explained: "This rating takes into account mostly return and value. And the JPMorgan product scores better on those two indicators," she said.

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