Barclays’ buffered digital notes tied to Russell 2000 offer lower-risk alternative to fund

By Emma Trincal

New York, Aug. 22 – Barclays Bank plc’s 0% buffered digital notes due Aug. 31, 2017 linked to the Russell 2000 index offer less risk than a direct equity investment thanks to a “hard” buffer, but investors have to agree to see their returns limited by the fixed digital payout, which acts as a cap on the upside, said Suzi Hampson, structured products analyst at Future Value Consultants.

If the index return is zero or positive, the payout at maturity will be par plus a digital percentage of 15% to 18%, with the exact percentage to be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index declines by 20% or less and will lose 1% for every 1% that it declines beyond the 20% buffer.

Lower risk proposition

“It’s a lower-risk version of a direct exposure to the index,” said Hampson.

“You have less downside risk exposure than if you were to buy the shares of the equivalent index fund, but you also have to give up the upside above the fixed digital payout.

“You get a digital payout of 15% to 18% if the index finishes up positive. So in a very small growth or flattish market, you can outperform the index. And on the downside, you have a 20% buffer.

“The payout is a series of jumps. If you’re above 80, you get your capital back. If you’re above 100 the return jumps to the digital and not higher. And if you’re below 80, you lose your capital on a one for one basis but only beyond the buffer level so, assuming there is no credit event, you’re going to get at least 20% back,” she said.

The “downside” portion of the payout offered two benefits – return enhancement and protection, she said.

On the upside, any index performance below the digital would bump up the payout at the digital level. This type of return enhancement would have the maximum impact in a flat market, she said.

“It’s a relatively low-risk proposition. Your capital is still at risk but the large buffer and the one-to-one gearing will allow you to outperform the index. The upside offers a quite modest return, but you’ll be paid that if the index finishes above 100.”

The Russell 2000 index is a well-known underlying. For investors who want exposure to the U.S. small-cap market, the notes offer a way to “significantly reduce the risk” compared to a direct investment in the index fund.

“It’s a relatively easy-to-explain structure, not just because investors are familiar with the benchmark,” she said.

“All you really have is three scenarios. Either the index is down by more than 20%; or it’s down by less than that amount; or finally, the index is positive and regardless of how much, you get your payment.

“In a relatively flat, very moderately up market, you have a chance to outperform the index. Say the S&P is up only 3% or 4% a year, this note will beat the market.”

A very bullish investor however would avoid the notes as the best return enhancement is provided in a small growth scenario.

“This product is not really aimed at bulls. It’s more designed for investors who predict that the market will go sideways,” she said.

The choice of the Russell 2000 index versus the S&P 500 will “add a little bit more risk” to the product, she said. That’s because the Russell 2000, with a one-year implied volatility of 20% is more volatile than the S&P, which has a volatility of 14.5%.

“The volatility is one thing but overall, if you look at the structure...a one-year term and a 20% buffer...there’s quite a lot of capital protection built into this product,” she said.

“Investors in this note have to be more risk-adverse than average. But it’s still a capital-at-risk product. Each time you’re talking about capital at risk, an investor has to be prepared to lose capital. And even though the structure offers a large buffer, you still can lose up to 80% of your capital.

“This note is going to be appealing to people who want to reduce the amount of risk they’re taking when getting exposure to this index. They can reduce the risk but of course, there is still risk as the riskmap illustrates.”

Future Value Consultants generates a riskmap, which is its own score measuring the risk associated with a product on a scale of zero to 10. Ten is the highest level of risk possible. The riskmap is the sum of two components: market risk and credit risk.

The research firm also rates return and value through its return score and price score. For each rating, the product is compared to “all products” as well as the average for the “same product type,” which in this case would be digital.

Market and credit risk

The notes have a market riskmap of 1.74 versus 1.87 for the average of the same product type.

“The notes and the average for digital products look pretty similar although the notes show slightly less market risk,” she said.

“It could be the result of two factors that are cancelling each other out. One is less risk due to the large buffer. The other could be the additional risk induced by a volatility that’s higher than the S&P. One factor may offset the other,” she said.

The credit risk of the notes as measured by the credit riskmap is also very close to the average for the category at 0.71 versus 0.60 for the group average.

“Most of those digital notes have a one-year or two-year duration. This one is longer. The slightly higher credit riskmap is likely to be maturity-related rather than issuer-related. Barclay’s credit is not bad. Its CDS spreads are rather tight,” she said.

Barclays’ five-year CDS spreads are 59 basis points, according to Markit. Inc. For comparison, Goldman Sachs shows 77 bps, Morgan Stanley 75 bps and Bank of America 67 bps.

Risk reward

Future Value measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions – neutral assumption, bull and bear markets, and high and low volatility environments.

The return score is calculated based on the best among the five return scenarios, which for this particular product would be the bullish one, she explained.

The notes have a 6.92 return score versus 7.18 for the average of that same product type.

“We have five scenarios. You can only have so many,” she said.

“With this product, the best returns will come from a flat, modest-growth market environment, which is a little bit like the low volatility assumption but not quite. In reality, even with this type of payout, the bullish scenario will end up being the best of all because if it’s bullish, you’ll still get the best returns.”

The notes did not show a very high return score in comparison with the average of all products, which is 7.09. Hampson offered an explanation.

“A different type of structure, which would also fit into the category of bullish, for instance a no-cap leveraged note, would give you a much higher return potential than this one because here you have the cap,” she said.

“So even though we had to select the bullish scenario for the purpose of scoring, obviously other product types will do much better under the same market assumption.”

Value

For each product, Future Value computes a price score that measures the value to the investor on a scale of zero to 10.

This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The price score of the notes is 7.18. In comparison the score for the structure category is 7.93.

“It’s slightly below the product type. The score suggests that the issuer maybe could have offered a higher coupon,” she said.

“Perhaps options on the Russell are slightly less liquid than on the S&P although it’s unlikely. Another factor could be that digital products as a structure type are not a very populated category. You have fewer digital notes than leveraged return or reverse convertible. That means you probably have less competition, especially if it’s based on the Russell. The low-risk, low-return signature of this product may also not be very common.”

Overall score

Future Value Consultants uses its overall score to give its general opinion on the quality of a deal. The score is the average of the price score and the return score.

The overall score for the product is 7.05 versus 7.55 for its peers.

“This product has quite a good buffer. The risk-reward profile could have been improved if the issuer had offered a little bit more return for the same amount of risk. But overall, it doesn’t look bad. The overall score is a little bit under average for the same product type but comparable to all products,” she said.

The “all-product” overall score is 7.02.

Barclays is the agent.

The notes will price Aug. 27 and settle Aug. 29.

The Cusip number is 06741UGW8.

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