Barclays notes on VIX Short-Term Futures ETN seen as first-time use of an ETN as an underlying

By Emma Trincal

New York, Oct. 14 - Barclays Bank plc is set to price Friday a deal believed to be the first product based on an exchange-traded note, sources said.

Barclays plans to price 0% buffered Super Track notes due Nov. 18, 2011 based on the performance of the iPath S&P 500 VIX Short-Term Futures ETNs, according to an FWP filing with the Securities and Exchange Commission.

"I've never seen a structured note linked to an ETN before. It's pretty interesting," a sellsider said.

"There are many products tied to [exchange-traded funds] out there. But I think it's a first on an ETN," said Michael Johnston, analyst and founder of ETF Database.

Sources said that the use of the iPath S&P 500 VIX Short-Term Futures ETN - or "VXX" - as an underlying was facilitated by the Chicago Board Options Exchange's decision in May to begin trading options on it.

Structuring a product requires the ability to hedge the underlying through the use of options, they noted. The more liquid, the more available and the cheaper the options on a security are, the easier it is for structurers to hedge the note.

Cost

But critics of the new product argued that the new notes may end up costing investors more in fees than the ETN itself.

The prospectus did not provide any details on the fees.

A market participant said that "it would be interesting to know" whether investors in the new notes would be charged a fee on top of the ETN fee.

"I wouldn't be surprised if it was more expensive than the ETN," said Johnston. "People can't do it efficiently on their own."

"I think you're going to have a double layer of fees," the sellsider said. "The bank is going to make money on the notes. And they're going to have to hedge the underlying ETN; therefore, some expenses are going to be passed on to the investor.

"But I don't think the fee is such a big deal. In the equity asset class, the magnitude of the returns tends to be much greater than the amount of fees."

A spokesperson at Barclays declined to comment on the new product.

Battered ETN

Another possible objection to the deal, critics said, was the poor performance of the underlying VXX ETN, which is down nearly 56% this year. By comparison, the VIX index itself, which is not tradable, has declined by only 5% in the year to date.

The explanation for this disparity of returns, given that the VIX and VXX are correlated, has to do with the changes in prices of the futures contracts that comprise the S&P 500 VIX Short-Term Futures index, explained Johnston.

"The VXX invests in futures contracts. It's only impacted slightly by the change in spot prices. What really matters is the roll yield, the futures market and the potential contango. VIX futures have gone through a lot of contango recently," he said.

The contracts are replaced as they approach expiration by similar contracts with a later expiration, a process referred to as "rolling."

A rolling curve will be negative or in "contango" if the prices of the contracts in the distant delivery months - those that must be bought - are more expensive than the contracts in the nearer delivery months due to be sold.

The prospectus warned of the negative roll yield in its risk section, stating that "VIX futures have frequently exhibited very high contango in the past" and that the "significant cost to roll the futures" could "decrease the payment" investors receive on their notes at maturity.

"If you want exposure to volatility, I don't know why you wouldn't go for the ETN," said Johnston. "I would go straight for the ETN and cut the middle-man."

The benefits of structuring

Despite the perceived drawbacks, market participants said that the new notes are promising because the structure itself offers benefits that the ETN does not offer.

Those benefits were described as the enhanced returns and the partial protection.

The payout at maturity will be par plus double any gain in the underlying ETN, up to a maximum return of 43.1% to 46.2%, with the exact cap to be set at pricing, according to the prospectus. Investors will receive par if the underlying ETN falls by up to 20% and will lose 1% for each 1% decline beyond 20%.

"The cap is reasonable for a one-year note, and I like the fact that it's a one year," said Steve Doucette, financial adviser at Proctor Financial.

"It might be a great opportunity to hedge an equity portfolio if the market gets ugly. And if you're wrong, if volatility declines, you still have a decent 20% buffer. It's an interesting play on volatility."

Brad Livingston, a distributor at Laidlaw & Co.'s Income Solutions Group, said that he believed the product offered some benefits as well compared to the ETN.

"If you can increase your upside while limiting your downside risk, I think it has potential," he said.

"The advantage compared to the ETN would be the two-times leverage with a 20% buffer. If you think your ETN will go up only moderately, you get two times that.

"For a one year, 46% is a pretty nice cap. The VXX would have to go up 23% to bust the cap."

The sellsider said that the notes were not without risk. While the investment offers protection against a market sell-off, the risk is great when the market recovers or turns bullish. Yet, he said that overall, the protection offered to the investors with the buffer remained attractive.

"It looks like the VXX has been drifting down. It can easily go down, so there's a risk," he said.

"However, I still think it's something fairly safe, so to speak. It's built for someone who anticipates a volatility spike and wants to double the return on the spike. At the same time, it's designed for someone who wants to build as much protection as possible."

The notes (Cusip 06740PTB2) will price on Friday and settle on Wednesday.

Barclays Capital Inc. is the agent.

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