Barclays' principal-protected notes tied to S&P BRIC 40 index: a safer play for risky markets

By Emma Trincal

New York, May 27 - Barclays Bank plc's upcoming principal-protected notes linked to the S&P BRIC 40 index offer investors a way to invest in the growth of the four leading high-growth economies without being exposed to the sharp volatility swings and downside risk that characterize these regional equity markets, sources said.

Barclays plans to price zero-coupon 100% principal-protected notes due June 30, 2016 linked to the S&P BRIC 40 index, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par plus any index gain, up to maximum return of 48% to 54%. The exact cap will be set at pricing.

Investors will receive at least par.

Price swings

Brazil, Russia, India and China, known as the BRIC countries, have the fastest-growing economies in the world, but the volatility of the stocks in these countries is very high, said Paul Weisbruch, vice president of ETF/options sales and trading at Street One Financial in New York.

The S&P BRIC 40 index consists of 40 component stocks designed to offer exposure to the stock markets of the four BRIC countries.

In order to be in the index, a stock has to be domiciled either in Brazil, Russia, India or China; in addition, each stock must have a float-adjusted market capitalization above $1 billion.

The SPDR S&P BRIC 40 exchange-traded fund, which tracks the index, was up 65% last year but down nearly 6.5% this year. The last five years posted a 3.33% loss.

Weisbruch said that volatility is high for BRIC stocks and that investors may see their gains one year erased the next. As a result, he said, a lot of money has been leaving China this year, looking for safer markets.

"Those countries were big alpha generators last year. But China has been hammered this year," said Weisbruch.

"With those BRICs, you get about two times the volatility of U.S. stocks. Just today, for instance, the S&P 500 is up 3% and [the SPDR S&P BRIC 40 ETF] gained 6%," he said.

"You get the upside when there's a bull market. But if the market falls, you get more downside."

U.S.-correlated

Another risk with investing in the stocks of these countries is that correlation with the U.S. stock market is high, said Weisbruch.

"I don't think you'll see the U.S. down and the BRICs up or vice versa. There's definitely a high level of interrelation between the economies," he said.

"Brazil needs to export its wood, oil, resources, and if there is appetite in the U.S. for those products, the revenues are passed back to Brazil. China, with the exchange-rate issue notwithstanding, is big on building infrastructure and so is India. How sound is the Chinese economy at the moment as they own so much of our own outstanding debt is unclear," he said.

Fear of a bubble in Chinese markets has led investors to cut their investments in China, said Weisbruch, which adds to the uncertainty around the performance of BRIC stocks.

"When the market is good, you get a lot of alpha. Last year's returns show that it's very possible to get high double-digit returns in one year. But when those markets reverse, losses can be significant. Because of the risk, people tend to reduce their allocations to these countries right now, in particular to China," said Weisbruch.

Structure benefits

Talking about the principal-protected note as an instrument to get exposure to BRIC stocks, Weisbruch said, "It sounds like a safer way to play most of the upside and at least, you cap the downside. It's almost like an index annuity."

With a principal-protected note, the issuer, in order to hedge and pay the return up to the cap, buys a call on the underlying security. The call provides the upside while the protection is obtained through the zero-coupon bond, according to market participants. As a result, the cheaper the call option, the better the terms may be, market sources said.

"I would think that options in any BRIC-related stock tend to be pricey because price swings tend to be dramatized," said Weisbruch.

"My guess is that they were able to offer this cap by extending the maturity to a six-year," he said.

Tenor

However, some investors are not comfortable with one of the main risks associated with principal-protected notes.

If the index return is not positive, investors will not receive any payment at maturity other than their principal, as stated in the prospectus.

"We wouldn't do a pure index-based play over six years. Six years is way too long for us. Our maximum would be three years, especially if it's a principal-protected product and if there is no leverage," said Steve Doucette, financial adviser at Proctor Financial.

Doucette said that from an investment standpoint, he liked BRIC stocks

"These are resources-based economies that could do well. The BRICs could be an underlying that we may consider in the future but with different terms," he said.

Tax issues

One negative aspect of the investment in a principal-protected note, besides the long-term nature of the security, is taxes, Doucette added.

"Any gain you may recognize on the sale or maturity of the notes will be taxed as ordinary interest income," the prospectus said.

"We don't do principal-protected notes because we don't like the idea that gains will be taxed as ordinary income," said Doucette. "Your typical broker doesn't think of taxation. They talk to you about the principal-protection. That's all they worry about. But we think it matters."

Doucette said that he only looks at products that include a buffer, albeit a small one.

"As long as there is no 100% principal guarantee and even with a buffer as small as 5%, the tax consequences change and your payout is treated as capital gain," he said.

The notes will price on June 25 and settle on June 30.

Barclays Capital Inc. is the agent.

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