UBS' double short leverage notes linked to S&P 500 bet against market, can be used as a hedge

By Emma Trincal

New York, Oct. 24 - UBS AG, London Branch's 0% double short leverage securities linked to the S&P 500 Total Return index are designed to take a bearish bet or to hedge a long equity portfolio, but the risks and costs associated with the product may not make it the best security to achieve those objectives, some sources said.

The payout at maturity or upon redemption will be par minus 200% of the index return plus an interest amount and minus the accrued borrow cost, according to an FWP filing with the Securities and Exchange Commission.

The interest amount is equal to the interest accrued on $20 at a rate per year equal to overnight Libor, compounded daily.

Speculation

"There are two reasons for these notes: for speculating or for hedging," said Bill Thatcher, principal at Mercer Investment Consulting.

"I can understand the hedge, and you can put 50 to hedge 100 if you want to fully offset the losses on your equity positions."

But the use of the notes to make a directional bet against the S&P 500 was more puzzling to him as most investors in today's uncertain environment lack conviction and are trying to interpret how global events, in particular the European debt crisis, are going to unfold.

No view

"I probably wouldn't use it for speculation. It's hard to have a view. It's risk on, risk off, and risk on, risk off," he said.

"The market depends on what Merkel and Sarkozy are going to do or Ben Bernanke.

"During a crisis like today, we're at the hands of policy makers, and because of that people are wary about taking bets, whether bearish or bullish."

The notes are not principal protected. Investors can lose "all or substantially all" of their investment in the notes, according to the prospectus.

The leverage adds more risk.

"If the index finishes higher, losses will be double the positive index return, and the return on the securities will decline at a rate that will exceed the rate of appreciation of the underlying index," the prospectus said.

The notes are putable at any time, subject to a minimum of 100,000 securities, a feature that adds liquidity to the product.

Separately, the notes get called if the index increases by more than 35%. Such an increase would cause investors to lose 70% of their principal.

But a structurer said the automatic call is not designed to protect investors.

"It's actually a protection for the issuer who is lending to the client. They need a cushion, some stop to limit the losses.

"In a matter of a couple of days, the client may lose a lot, but the issuer could lose more. That's why they do that."

Hedge

For Thatcher, the notes would only make sense for an investor trying to hedge a portfolio that has a long exposure to equity.

"But maybe there's a cheaper way to do it," he said.

Investors in the notes are subject to an upfront fee and the accrued borrow cost.

The accrued borrow cost is a per-year rate equal to the borrow notional multiplied by the borrow rate. On any day, the borrow notional is $20 multiplied by the quotient of the closing level of the index on the preceding day divided by the initial index level. The borrow rate is 0.15% plus the greater of (a) zero and (b) overnight Libor minus the Fed Funds open rate.

The one-year notes have a par value of $10, and they will price at 102.55.

"You pay the fee upfront plus the other borrowing fees to be able to easily hedge a portfolio on a leveraged basis. But is it worth it? It depends. If it's more of a hassle to do it yourself, then I guess it's worth the fees," Thatcher said.

ETF alternative

Greg Werlinich, president of Werlinich Asset Management, LLC, doesn't think so.

"I don't know why anyone would do this," he said.

"There are so many leveraged, inverse ETFs out there - the ProShares, the Rydex, the Direxion," he said referring to fund providers.

"You can buy and sell anytime. You trade intraday. You're not locked up more than five minutes, even less so a year."

But the structurer said that notes can offer advantages over an ETF when it comes to leverage.

"The ETFs have a daily reset versus these notes that have a payout at maturity," he said.

"Here after one year, they look at the index performance and they pay you two times the inverse return, whereas in an ETF, they reset it daily.

"You know how it is: If you go down 50%, you need to go up by 100% to make back the next day. That's the problem with the daily reset."

Werlinich said that the notes do not offer an attractive risk/reward profile compared to other structured products.

"It's not an interesting security. I've seen structured notes that give you a significant high yield to offset the risk," he said.

"Here, you've got no yield. You're just making a bet that the market is going to go down. I don't like it."

UBS Financial Services Inc. and UBS Investment Bank are the underwriters.

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