Deutsche Bank's absolute return notes tied to iShares MSCI EM combine hard buffer, short tenor

By Emma Trincal

New York, March 13 - Deutsche Bank AG, London Branch's 0% securities due April 17, 2015 linked to the iShares MSCI Emerging Markets exchange-traded fund provide investors with an absolute return payout and a buffer, a combination that is somewhat unusual, especially on a short-term product, said John Farrall, senior vice president, director of derivatives strategies at PNC Wealth Management, adding that he likes the notes.

The payout at maturity will be par plus any fund gain, up to a maximum return of 10% to 13%. The exact cap will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the fund return is negative but the fund declines by no more than 10%, the payout will be par plus the absolute value of the return. Otherwise, investors will lose 1.1111% for every 1% that the fund declines beyond the 10% buffer.

No contingency

"What I like about this structure is that it's not a contingent protection. It's a hard buffer," Farrall said.

"I haven't seen that many buffers with that type of structure. It's not very common at all.

"On the upside, you get one to one up to a cap. And on the downside, if you're down up to 10%, you get the absolute return.

"We've done absolute return deals before with a barrier, and it scared the hell out of me when you get knocked out because you end up losing a lot more than the protection. You lose the absolute return as well.

"With this, if the index is down 11%, you lose 1.11%. You would have to be down 20% to lose 11%. The buffer takes away the big worry associated with those contingent protections."

As an example, assuming an 80% barrier, one additional percentage point of index decline could make an investor's portfolio move from a 20% gain to a 20% loss, he explained.

The short maturity is attractive too.

"The 13-month [tenor] is good from a tax standpoint. Most of our clients are taxable accounts, so 13 months is great because you get the capital gains for the next tax year," he said.

Another characteristic of the trade, he said, is the use of this emerging markets benchmark while many absolute return deals tend to be linked to the S&P 500 index.

"We don't see a lot of those on this index," he said.

Extending the term

The short duration and the buffer came at a cost, however: the upside cap and a range of absolute return limited to 10% on the downside. One way to change that was to agree to a longer duration, a trade-off he said he would perhaps consider.

"I might extend the maturity up a few more months in order to get 15% on the upside and [a] 15% buffer on the downside," he said.

"I like it as it is right now, but to get a little bit of a wider performance on both sides, I could add a few more months. With that type of underlying, I may look at 18 months to 24 months in order to get that type of a range on both sides.

"If I went for a January maturity for instance, it would also push out my taxes for one more year, which would be attractive."

Bearish bias

Steve Doucette, financial adviser at Proctor Financial, said that he has noticed more absolute return products recently.

"It's kind of nice to see them coming back," he said.

"It's tilting toward somebody who is more bearish than bullish because your upside is only the index capped. You don't expect the market to go up more than 10% to 13% over the next 13 months. And since there's no leverage you're sort of giving up the upside for the downside. It may still work though for someone who wants the exposure and who is unsure about the direction of the market."

But the real value of the structure is on the downside, he said.

"You can outperform the index if it goes down. Should we have a pullback of less than 10%, you get a great outperformance scenario," he said.

Doucette said that his firm worked with Deutsche Bank before on some absolute return products.

"We like them and we would continue to work with them. But those deals had knock outs, and we were busted out. So in that regard, having a buffer is very attractive," he said.

Cap

If the client has a neutral or slightly bearish bias, the limited upside should not be too much of a concern, he said, unless the market rallies.

"While you're one-to-one on the upside and capped, I don't think anybody is going to complain about 10% over 13 months," he said.

"It's another story if the market is up 20%. In that case your clients are not going to be happy that they're only getting13% when the market is up 20%. Clients tend to forget that they made the decision a year before to give up the upside because they wanted to add protection.

"That's why we look at outperforming on either side."

No knock out

Doucette agreed that the buffer is attractive.

"The problem with these structures is when you get knocked out. The problem is market volatility," he said.

"So in some way, the buffer brings a solution to this. It's a very nice feature to know that your first 10% are protected. You're not getting knocked out. You fund that buffer with the gearing on the downside. But as long as you don't believe that you won't go way down, the downside leverage is not such a big issue. And it really pays off to go down a little bit."

A market participant said that buffers offer the advantage of being easy to understand.

"But it's not easy to price," he said.

"The reason you have the gearing is to provide better economics. It allows you to add the downside protection. Or in certain structures, it gives you more upside potential. With this deal, it looks like they're using it to price the buffer.

"You're not going to see a 10% straight buffer on a 13-month note without the downside leverage. You may see it on a two-and-a-half year [note]. Not on 13 months."

Doucette said that any comparison between buffers and barriers should be done with a clear goal in mind and on a case-per-case basis.

"Extending the range with a knockout is one way to get more both up and down," he said.

"Obviously, if you had a knock out, you would get a wider range than 10% down and 10% up.

"The question is, how much? It's hard to predict the range that you're going to need, and because it's not easy to predict, I lean toward that buffer.

"The trade-off from buffer to knock out is OK if I'm getting more range for the absolute return and the upside. It would depend on how much more I'm expanding that envelope up and down and if I'm comfortable with that.

"But in general, without knowing how big of a range I would get, I'd rather have the buffer than the knock out. At the end, we're definitely better off with it."

Type of protection

The market participant said that barriers may have their appeal for this particular structure.

"People like buffers, but a barrier is not necessarily worse. It may actually be a good thing," this market participant said.

"The potential absolute return in this product is limited to 10%. In terms of pricing, looking at this type of underlying, a 10% buffer could probably be exchanged for a 75% barrier since a barrier is cheaper.

"Obviously, 25% would represent more protection and more absolute return than 10%. The protection may be contingent, but the range of protection, the potential for gains is greater."

Matt Medeiros, president and chief executive of the Institute for Wealth Management said that he does not have a preference for a buffer over a barrier.

Macro focus

"My preference would be determined on what the opportunity is and what my objective for the asset class is. Rather than looking at the trade-off - barriers versus buffer - I would want to pursue the appreciation of the asset class. I'm really more focused on the asset class objective than on the structure," he said.

"Emerging markets offer a very interesting value at this point. They've underperformed a lot but have recently appreciated.

"I like the short term because emerging markets are an asset class that needs constant monitoring, and it's a bit of a challenge to make a long-term allocation at this point.

"I am bullish short term, and while the 10% to 13% cap is the least attractive component of the structure, in light of the headwinds, having a 10% buffer more than compensates you for having a cap on the upside."

Deutsche Bank Securities Inc. is the agent.

The notes will price March 14 and settle March 19.

The Cusip number is 25152RJK0.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.