Issuers extend duration to construct 0% principal-protected notes with appeal, analyst says

By Emma Trincal

New York, Jan. 8 - "Issuers trying to price principal-protected structures are often forced to extend the maturity of their notes because interest rates are too low to make a structure attractive for short-term products," said structured products analyst Suzi Hampson at Future Value Consultants.

Hampson reviewed two comparable deals recently announced for pricing on Jan. 26.

Both will be brought to market by the same issuer, have the same maturity of six years, offer principal protection and present the same structure with the same cap and the same participation rate.

The difference lies in their respective underlyings.

"It's unusual, especially in the U.S., to see such long-term notes. A six-year stands out as unusual, especially for growth products," Hampson said.

Barclays Bank plc plans to price two zero-coupon principal-protected notes due Jan. 29, 2016, according to FWP filings with the Securities and Exchange Commission.

The payout at maturity for both structures will be par plus any underlying gain, up to a maximum return of 50% to 60%, with the exact cap to be set at pricing. Investors in both products will receive at least par.

What differentiates the notes is their respective underlyings: One consists of a basket of three equally weighted indexes, which are the S&P 500 index, Dow Jones Euro Stoxx 50 index and Nikkei 225 index, and the other is the S&P 500 index.

Cost of options

"You typically see long maturities either with callable or CMS [Constant Maturity Swaps] deals," said Hampson.

CMS-linked notes are typically steeper notes with a coupon based on the spread between two maturities, which is why they tend to have a long duration.

"I would guess the reason you're seeing principal-protected products with such long maturities here is simply a result of the very low level of interest rates in the U.S.," said Hampson. "In order to buy the bond and to give investors the principal protection with attractive terms, the issuer has to go longer, otherwise there would be nothing left to buy the options."

Hampson said that most principal-protected notes in the United States must have a tenor of at least one year and, more often, two years. "Anything shorter than that would not be very economically feasible," she said.

No risk, no leverage

The notes have a 100% participation rate, which is no leverage. Hampson said that the absence of gear with these notes is directly linked to the capital protection.

"There is a limited risk of losing your principal. So of course your potential return is going to be lower than with a principal-at risk product. When you have downside risk, you usually get a gear. In addition, you tend to get a higher cap."

Looking at the 60% potential maximum return featured in both transactions, Hampson said, "It's [a] 10% coupon annualized, and that's quite reasonable for a six-year."

Comparing the coupon to a Treasury of the same term, which she said would yield approximately 3%, Hampson said that the 10% annual coupon is attractive. She compared the notes to a government bond "because you're dealing with principal-protected products, not growth products." However, the notes differ from a government bond in that investors need the underlying to rise by 60% in order to earn the maximum coupon, she said.

Volatility and value

Most ratings were similar when comparing the two products, except for the so-called value rating. This indicator on a scale of zero to 10 is Future Value Consultants' measure of how much money the issuer spent directly on the assets versus other transaction costs such as direct fees and profit margin.

"Usually with a principal-protected product, the higher the volatility of the underlying, the more your product is valuable," Hampson said.

"That's because, the more volatile the underlying, the more likely it is to give you higher returns, which makes the cost of the option more expensive. If you compare two products with the same structure, it will cost the issuer more to buy the assets. Whenever the issuer spends more on the asset, you end up with more value," she noted.

The notes linked to the S&P 500 had a value rating of 9.35. Those tied to the basket of indexes were lower, at 8.71.

"The only explanation I see for this difference is that the S&P 500 is more volatile than the basket of three indices, which is not necessarily unlikely," said Hampson. "Anytime you put together a basket of indexes, you make a new index and the more constituents you have, the lower the volatility."

Risk and solvency

Risk, as defined by riskmap, a Future Value Consultants' rating that measures the risk associated with a product on a scale of zero to 10, was found to be exactly the same, 1.45, for both products.

"The structure is the same; both deals are principal-protected; and, since we also include credit in this rating, credit risk for those two Barclays notes is obviously the same," Hampson said.

Hampson said that creditworthiness of the issuer explained in part the very low riskmap.

"Barclays is a fairly stable credit compared to other issuers. Its credit default swap spreads are not as wide as most U.S. banks. The creditworthiness of the issuer here is especially important for risk assessment. These are long-term products. The longer the product, the greater the exposure to credit risk," Hampson noted.

Structure and returns

Risk-adjusted returns are also very similar for the two offerings. The return rating - Future Value Consultants' indicator, on a scale of zero to 10, of the risk-adjusted return of the notes - was 6.13 for the product linked to the basket versus 6.16 for the notes tied to the S&P 500.

Pointing to the probability table contained in her reports, Hampson said that investors in the notes linked to the basket have a 66.2% probability of earning a 5% to 10% return. This probability for the other product is 65.4%.

"This result can also be explained by the similarity of the structures. Both deals are principal-protected and both have a 60% cap. It's likely that you're going to get similar returns," said Hampson.

Value factor

Hampson concluded her analysis by comparing the two overall ratings of each notes.

The overall rating, on a scale of zero to 10, is Future Value Consultants' opinion on the quality of a deal, taking into account costs, structure and the risk-return profile.

The product that had the higher overall rating - at 8 - is the one linked to the S&P 500. The notes tied to the equity basket had an overall rating of 7.74.

"The value is the factor here. The product with the highest value rating also has the highest overall rating. Since both notes have similar structures and risk-return profiles, it makes sense that the differentiating factor would be value," she said.

Notes versus CDs

Hampson said that, as she sees more and more principal-protected notes with longer maturities, investors should carefully compare principal-protected notes with certificates of deposit when looking for principal-protected investments.

"I have seen longer terms in CDs, and clearly these notes are trying to compete with CDs," said Hampson.

"The notes don't have the same protection, but they probably offer a more efficient tax treatment," she added.

Both notes will settle on Jan. 29.

Barclays Capital Inc. is the agent.

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