Barclays’ $2.4 million notes linked to Russell 2000, QQQ eyed for downside leverage below one

By Emma Trincal

New York, May 18 – Barclays Bank plc priced a deal that was small but whose structure intrigued market participants due to an innovative feature.

The $2.4 million deal had a dual directional structure based on a worst-of payout. But the twist was downside participation for the absolute return set at half the normal rate. In exchange, the barrier was deeper than average, the cap competitive and the leverage factor high, sources said.

“This is leverage less than one on the downside range. I don’t recall having seen that before, but it looks very interesting,” a market participant said.

The 0% dual directional notes due May 18, 2020 are linked to the lesser performing of the Russell 2000 index and the PowerShares QQQ trust, series 1, according to a 424B2 filing with the Securities and Exchange Commission.

If the final level of the lesser-performing underlier is greater than its initial level, the payout at maturity will be par plus four times the return of the lesser-performing underlier, subject to a maximum return of 45%.

If the final level of the lesser-performing underlier is less than its initial level but greater than or equal to its barrier level, 60% of its initial level, the payout will be par plus 0.5% for every 1% that the lesser-performing underlier declines.

If the final level of the lesser-performing underlier is less than its barrier level, investors will lose 1% for every 1% that the lesser-performing underlier’s final level is below its initial level.

Merits of safety

“Forty percent in contingent protection, that’s a big number,” this market participant noted.

“You can probably convince more people of the merits of the product with a 60% barrier. More people will sign up for this as far as safety is concerned.”

The idea of giving only 0.5 time rather than one time the worst-performing index’s decline in absolute return is very innovative, he said.

“That’s how they can lower the barrier. It still looks OK. One-for-one would be nice, but to be honest, 0.5 is not bad. Certainly you can make the argument that if the market is down and the barrier not broken, you still come ahead of the game.”

Reducing the downside participation enabled the issuer to do a number of things, such as bringing up the cap for instance. In that case though, most of the money freed by the feature had probably been used to enhance the protection, he said.

“It’s not a lot of money you’re getting on it. But you can do what you want with it as an issuer. You can give some extra leverage or lower the barrier.

“What I assume they’re doing here is they showed different variations to clients, described the merits of each type of deal and customized it based on the client’s preference.”

The fee was only 25 basis points, according to the prospectus.

“It’s not a retail deal. Not with a low fee like that for a four-year,” he said.

Given the small size of $2.4 million, he concluded that the notes went to a single registered investment adviser.

Reasonable cap

Another appeal of the deal, he said, is that investors do not sacrifice too much on the upside. Many dual directional structures tend to cap the upside at low levels, making those products unattractive even in a slow growth market. This deal in comparison provides a “decent” cap, he noted.

The 45% maximum return is the equivalent of 9.75% a year on a compounded basis.

“This deal looks good. Less participation on the downside to keep the barrier at 60% is attractive. It’s a question of visuals. People are OK with 10% a year. In this market, high-single-digit returns are attractive. By shaving off the participation on the downside, you’re able to make a more realistic swing on the upside.”

Perhaps structurers should use this feature more often to make dual directional deals more enticing, he said. But he has yet to see those types of deals in the market.

“It’s not being done a lot. I suppose it’s because it looks more complicated. You can do something that looks good, but investors are already puzzled sometimes with dual directional. That may look too complex.”

A distributor said the “deal was definitely intriguing” after reviewing the terms of the notes.

“I like the structure. I’ve seen fractional participations before but not too often.”

Wider range

One of the objections brokers or advisers face when showing absolute return products is investors’ fear of breaching the barrier. In order to provide a reasonable cap while being able to offer the absolute return payout, structurers often have no choice but to cut the size of the barrier, creating greater risk if volatility picks up.

If the downside protection is reinforced, the opposite problem may arise. Caps may be too low, making those products more bearish in nature as probabilities of returns are greater on the wider downside range above the barrier, he explained.

“Instead of giving you one-to-one on the downside, which would probably get you to a 75% barrier, they reduced the participation to be able to afford the 60% threshold,” he said.

The range of profits between the 60% barrier level and the 140% cap is wider than usual, which is already an advantage, he added. But there is still a bias, only this one is more bullish.

“You’re playing for a positive return more than a negative return because your downside cap is 20% versus 40% on the upside,” he said.

He meant that investors may not earn more than 20% on the downside since the “cap” is 40% and the participation rate 0.5.

Gamma

“When barriers are too thin in order to elevate the upside cap, investors are taking on too much risk,” he said.

He gave an example based on a 25% barrier. An index price decline of 25% would generate a 25% gain while a 26% drop would cause a 26% loss. A small move in the underlying price can greatly modify the outcome, which is known in option jargon as “gamma.”

“By reducing the participation and lowering the barrier, you get less gamma risk,” he said.

“The chances of losing are smaller. The range of positive outcomes is wider.”

As a second example, he looked at the Barclays notes. The range of positive returns goes from 20% on the downside to 40% on the upside.

“It’s a 60% range. It’s wide and less risky,” he said.

“When you narrow down the barrier, you get far more upside, but your likelihood of breaching the barrier is much greater.

“This one does the opposite without sacrificing much on the upside. I like it.”

The notes (Cusip: 06741V2X9) priced on May 13.

Barclays was the agent.

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