Deutsche Bank's notes on S&P 500 offer gains in up-and-down market with barrier condition

By Emma Trincal

New York, April 11 - A leveraged and capped note offered by Deutsche Bank AG, London Branch offers positive returns whether the underlying S&P 500 index finishes up or down as long as the decline doesn't breach a barrier.

The investment is a good fit for investors who have a neutral outlook on the U.S. market and who seek absolute returns, sources said.

Deutsche Bank plans to price 0% capped absolute return barrier securities due April 14, 2014 linked to the S&P 500 index, according to an FWP filing with the Securities and Exchange Commission.

If the index finishes at or above the initial level, the payout at maturity will be par plus 120% of the gain, subject to a maximum return of 43.2%.

If the return is negative and the index has not closed below the barrier level of 60% of the initial level during the life of the securities, investors will receive par plus the absolute value of the index loss.

If, however, the return is negative and a barrier event has occurred, investors will be fully exposed to the loss.

For most portfolios

"If you breach the 60% barrier, you're not taking on more risk than if you were exposed to the S&P 500. And if you don't breach the barrier, your loss converts into gains," said Carl Kunhardt, director of investment management and research at Quest Capital Management.

"I would be very tempted to use it for an aggressive investor but also for a moderate portfolio. I don't see any reasons why I wouldn't use it in any portfolio except for a conservative one."

Kunhardt compared the protection feature of this deal with a traditional buffer. He concluded that the absolute return barrier was more attractive than a buffer for investors who can tolerate risk.

He compared two positive outlooks: one, in the case of the buffered notes, in which the underlying index would not decline by more than the buffer amount; the other, in the case of the absolute return notes, when the index would not hit the barrier at any time during the life of the notes.

In the first case, the investor would get par at maturity, he explained, whereas with Deutsche Bank's deal, a decline in the index of less than 40% triggers a gain for the investor of the same amount despite the negative performance of the index.

Barrier event

"You could end up negative 35%, [and] as long as you never hit that barrier, your payout at maturity is a positive return of 35%," said Kunhardt.

"It's the first time I've seen something like that. I guess if they did a lot of them, they'd go broke. You wonder how they can even price it."

A market participant said that the notes use a down-and-out put. With this option, a put expires if the underlying hits the barrier. But if it does not, the put remains in place securing the positive return.

Kunhardt said that the main question investors should consider is whether the barrier event is likely to happen in three years.

He checked the return of an investor who would have bought the same note three years ago. The 60% barrier would have been breached several times in September through October of 2008 and in March of 2009, he noted. But the performance of the S&P 500 would have been flat from then to now.

"Investors would have ended up with no losses and no gains. It would have been an opportunity cost. There are worse outcomes than that," he said.

Kunhardt said that he liked the fact that breaching the barrier did not mean the absence of potential gains at maturity.

"The barrier could have been breached, but the index could have gone back up, in which case, you end up with a gain. And your leverage applies to the upside only, which is also good," he said.

Neutral outlook

John Farrall, senior vice president, director of derivatives strategies at PNC Wealth Management, said, "For someone with a neutral outlook, it's a good structure."

Farrall also compared the barrier element of this deal with a buffer.

"Someone interested in these notes is less bullish than an investor in the standard buffered accelerated note," he said.

"This note is for someone who would think: I expect negative returns, but I don't expect the index to fall by 40%. It could go up or it could go down. But I don't see it going down a lot. And if it goes down by less than 40%, I want to benefit from it."

In comparison, the investor in a buffered product is "more bullish," according to Farrall, who said that they anticipate the market will go up but just want to protect some of their principal in case they are wrong.

No added risk

Farrall also noted that just because the barrier is breached during the term doesn't mean investors cannot generate a positive return at maturity.

"If it's breached, you can still make your 1.2 times any gain up to a cap. Of course, you'd have to go back up almost 70%. But it's not undoable on a three-year note," he said.

The occurrence of the barrier event only eliminates the downside absolute participation, he explained.

"All it does is to change your payoff. But it's not different from buying the S&P 500 without optionality. It's not adding much of a risk," he said.

Farrall said that he used to see similar structures "a while ago" but has not seen many recently.

"It's called a twin-win. I hear that it's a very popular structure," he said.

"To me, it indicates that there is less certainty over the future direction of the market. People aren't sure the market will be up or down. They just don't anticipate that it's going to decline a lot," he said.

The notes (Cusip: 2515A15U1) will settle on April 14.

Deutsche Bank Securities Inc. is the underwriter.

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