Structured Product Analysis: March Structure No. 5 - A Fair Buffered Capped Leverage Return Note

by: Reid Guenther

Summary

Detailed analysis of structure 5 from the March survey.

Results detail why this is expected to be a fair investment but not expected to be a good investment.

Link at the end provides a data file that should be of use in helping you evaluate similar products.

This analysis covers structured product No. 5 in my March structured products survey. This article should prove indispensable in helping you understand the risks and rewards of this product and why it should on average only be a fair investment.

The Structure

The following table contains the basic information about the product:

This structure is not principal-protected ("NPP"). The underlier is the S&P 500 (SPX) and the term of the product is 20 months. The payoff is buffered in that the initial loss of the investor's principal starts at 0% at a negative underlier return of -12.5%. However, the rate of loss is leveraged so if the underlier's return is -100%, the investor will lose all of their initial investment (see the payoff logic and graph below). A leverage factor of 1.4 is applied to positive returns up to 14.7%, at which point the payoff is capped at 120.58%. More details regarding the product and the issuer can be found using the SEC's EDGAR search engine by looking up the product's CUSIP, 48128GPQ7.

The relative payoff logic of the structure is detailed below:

Though the logic gives payoff specifics, for this product that logic is complicated enough that the possible payoffs are more easily understood upon viewing this payoff graph:

It is interesting to note that there is leverage applied on the upside
and the downside. Intuitively it appears that the downside leverage
has a more negative effect on the product value than the positive effect of the upside leverage. How this plays out will be discussed in the analysis section.

Below are the valuation results of the product as of 03/11/2016 which were given in the aforementioned valuation survey article:

As of the analysis date, the trade date has already occurred. Thus, the issuer's estimated price has been positively affected by the subsequent +1.5% rise in the S&P 500. However, since the product's maturity is still almost 20 months away, this effect is not large; (it's less than 0.5%). The historical and scenario estimated valuations have also been positively affected by the rise in the underlier but again that effect is not large. The historical value is reasonably good at 103.31% while the scenario expected product value is just above fair at 100.77%.

The Analysis

This graph shows how the product would have performed over a past period covering 10 years of start dates and thus encompassing a full economic cycle. Also, the relative performance of the S&P 500 is given to show how it relates to the historical discounted payoffs.
Click to enlarge
Those payoffs have been discounted using a structure discount rate that has been generated using the capital asset pricing model. This allows the computed relative value to be a measure of the risk versus reward of investing in this structured product as opposed to investing in the underlying market which is the S&P 500 in this instance.

The annually compounded structure discount rate for this product is 4.41%. And so, the 120.58% capped payoff actually has a discounted value of 112.03% while a 100% return of principal payment has a discounted value of 92.91%. The discounted capped payments are easy to pick out in the graph as they form flat regions in the payoffs during periods when the market is steadily rising.

The discounted payments only returning the investor's principal are much fewer in number as that payoff condition occurs just before and after the market peak in 2007 as well as the second to the last point in 2014. The large drop in value over that market peak occurs due to the market bottoming a little less than 2 years later. There are a number of other times when the payoffs drop below the capped level but none are below the 92.91% level where the investor would experience a loss of principal.

How the payments are distributed is shown in the following graph:
Click to enlarge
76% of the discounted payments are at and above 100%. The payoff cap is easy to pick out as the large spike above 110%. The 100% return of principal payment is the small spike above 90%, and the loss of principal payments are spread out between 90% to just below 50%.

Now compare the historical payoff distribution to the corresponding scenario analysis distribution:
Click to enlarge
For this analysis, 10,000 simulations were performed. They used the same structure discount rate as well as the historical average return and variance of the S&P 500 over the same period as the historical analysis. You see the spike due to the cap in payoffs is now only about 43% of the payments whereas it was about 68% for the historical analysis. But the spike due to the 100% return of principal is much larger for the scenario analysis and the drop-off of the loss of principal payments is much more pronounced as well.

That shift in the percent of capped payments and larger number of discounted payments below 100% is the reason for the difference between the historical valuation of 103.31% and the scenario valuation of 100.77%.

In Conclusion

Given that I generally place more emphasis on the scenario analysis results as they tend to be more conservative than the historical results, I would conclude that this structured product is fairly valued at just above 100% but I would not recommend it as a good investment. In my next article, I will discuss a structure that is the same type as this one, but because of some seemingly minor differences, that product turns out to be a bad investment.

To further assist with understanding this analysis and to possibly help you analyze similar products, here is the historical data and payoff logic used in the historical portion of this analysis.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.