Deutsche Bank’s capped absolute return notes tied to S&P 500 may outperform, but risk is high

By Emma Trincal

New York, April 9 – Despite the appeal of a short duration and absolute return payoff, Deutsche Bank AG, London Branch’s 0% capped absolute return knock-out notes due Oct. 19, 2016 linked to the S&P 500 index present risks given the height of the market and the thin barrier, sources said.

One adviser noted that the short duration does not help mitigate the risk.

If the final index level is greater than or equal to the initial level, the payout at maturity will be par plus the index return, subject to a maximum return of 14.7%, according to an FWP filing with the Securities and Exchange Commission.

If the index return is negative and the final index level is at least 85.3% of the initial level, the payout will be par plus the absolute value of the index return.

If the index finishes below the 85.3% knock-out level, investors will receive par plus the index return, with full exposure to losses.

The final index level will be the average of the closing index levels on the five trading days ending Oct. 14, 2016.

Excess return

“You’re not going to outperform on the upside. You’re long the index and capped out,” said Steve Doucette, financial adviser at Proctor Financial.

“The only time you can outperform is if the index goes down by less than 14.7%.

“Your view is pessimistic on the market. Eighteen months from now, you’re hoping to capture an absolute return, which would be huge, especially if the market is down 14%.

“But knowing how quickly the market can shift, I don’t really like the notes themselves. You’re betting on a narrow range from zero to negative 14.7%. If you’re outside that range, you’re long that index, and on the upside, you cap yourself out.”

Short term, shorter range

The short duration of the notes may reduce the odds of beating the benchmark, he explained.

“As you think of tying up your money for 18 months, it seems like a bet that only gives you a narrow range in where you would outperform,” he said.

“We did absolute return notes in the past. We liked them. But the ranges where you could beat the index were much wider then. It’s not the case with this one here. I suppose it’s because the notes are too short. You don’t get enough room between zero and the barrier level to be able to outperform. It’s probably what it is.”

Protection first

Steven Kaplan, founder and portfolio manager at TrueContrarian Investments LLC, found the amount of downside protection insufficient regardless of the benefits of the absolute return feature.

“I would just want more downside protection. I think you need something like 30% because historically, if a stock market is as high as the S&P is today, it will be down more than 30% in a year and a half,” he said.

“If you go back to Feb. 5 of 2014, it was at 1,751. If the market was to drop to that level again, it would be a drop of more than 15%.”

The S&P 500 closed at 2,092 on Thursday.

“Things can always go back to where they were the previous year,” he added.

“The upside cap is not a bad thing.

“What I don’t like is that we could easily drop by 20% a year and a half from now.

“Take the S&P level of Oct. 9, 2013, which is exactly 18 months ago. The index then was at 1,646. If we go back to this level, we’re already seeing a more than 20% drop.

“I think there’s just not enough downside protection in the structure.

“I understand that you get the absolute return. But that’s only if you don’t breach the barrier. The odds of breaching that barrier are pretty high.

“Based on normal market volatility you want to have more downside protection for something like that.”

JPMorgan Chase Bank, NA and J.P. Morgan Securities LLC are the agents.

The notes will price April 10 and settle April 15.

The Cusip number is 25152RC35.

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