Structured Product Analysis: March Structure No. 6 -- A Bad Buffered Capped Leverage Return Note

by: Reid Guenther

Summary

Detailed analysis of structure No. 6 from the March survey.

Results detail why this is expected to be a bad investment.

Link at the end provides a data file for use in helping you evaluate similar products.

The analyzed structured product is structure No. 6 in my March structured products survey. This article should prove indispensable in helping you understand the risks and rewards of that product.

In my last article covering structure No. 5, I analyzed a product very similar to structure No. 6, but determined that structure No. 5 was fairly valued. The analysis of this structure will show that due to a couple of seemingly minor differences, the product is expected to be a bad investment.

The Structure

The following table contains the basic information about the product:

The structure is not principal-protected ("NPP"). The underlier is the Russell 2000 (RTY) and the term of the product is 2 years. The following payoff logic gives meaning to the payment features mentioned in the previous table.

The payoff is buffered in that the initial loss of the investor's principal starts at 0% at a negative underlier return of -10%. However, the rate of loss is leveraged at 1/90% so if the underlier's return is -100%, the investor will lose all of their initial investment (see the payoff graph below). A leverage factor of 1.5 is applied to positive returns up to 19.34% at which point the payoff is capped at 129.01%. 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, 94986RG47.

The following graph helps you visualize the payoff logic.

As you can see the basic form of the payoff is the same as structure No. 5. However, the scenario valuation results as of 03/11/2016 in this table indicate that structure No. 6 is below fair value:

Here is the structure No. 5 valuation table for comparison:

Looking at the historical and scenario relative values of structures Nos. 5 and 6, you see that while the historical value of structure No. 6 is 0.72% above that of structure 5, the scenario relative value of structure No. 6 has dropped by 3.2%. A clue as to why this is so is found upon examining the relative volatilities. The reason for that difference will be discussed in the next section, though I would imagine you know why that increase in scenario volatility would be expected to occur.

The Analysis

This graph shows how structure No. 6 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 Russell 2000 is given to show how its performance relates to the historical discounted payoffs.
Click to enlarge
Those payoffs have been discounted using a structure discount rate that was 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 the structured product as opposed to investing in the underlying market which in this case is the Russell 2000.

The annually compounded structure discount rate for this product is 5.25%. Thus, the 129.01% capped payoff actually has a discounted value of 116.47% while the 100% return of principal payment has a discounted value of 90.28%. As in structure No. 5, 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. Of course that capped return can quickly drop as the market experiences downturns, with those drops exacerbated by the leverage factor.

The discounted payments returning the investor's principal are much fewer in number, with a few of them occurring in 2006 before the market peak in 2007. A few more occur after that peak and the third to the last point in the graph also represents a return of principal payment. Discounted payoffs below 90% occur not only in that period before the financial crisis but also on the right side of the graph due to the recent downturn in the market.

How the historical discounted payments are distributed is shown below:
Click to enlarge
66.9% of the discounted payments are at and above 100%. The payoff cap is easy to pick out as the large spike midway between 110% and 120%; 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 scenario analysis discount payment 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 Russel 2000 over the same period as the historical analysis period.

You see that the spike due to the cap in payoffs is now only about 40% of the payments, whereas it was about 55% for the historical analysis. But the spike due to the 100% return of principal payments is larger for the scenario analysis at about 15% compared to about 9% for the historical case. Also, the drop off of the loss of principal payments is much more pronounced and goes below a discounted value of 40%.

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 104.03% and the scenario valuation of 97.57%. Now also note, the historical variance of the Russell 2000 is much higher than that of the S&P 500 which was the underlier used in structure No. 5. This higher underlier variance means that a higher variance was used in the scenario simulations. The higher variance means that you can expect both higher and lower underlier returns. Given this, you would expect a larger number of negative returns for structure No. 6; while the higher relative cap of structure No. 6 would be expected to compensate for those expected losses, the scenario value of 97.57% shows that it was not enough to offset the potential losses. Thus, this structure is deemed to be a bad investment.

In Conclusion

As the analysis showed, this structure is a bad investment mainly due to the higher volatility of the underlier, the Russell 2000. Compare this to structure No. 5 which had a fair value. Though the payoff logic is very similar to structure No. 6, structure No. 5's underlier is the S&P 500. Given that the Russell 2000 is the more volatile index on average, structures dependent on it will tend to be riskier. Thus, the reward should increase enough to compensate. Unfortunately that is not the case for structure No. 6.

To further assist with understanding this analysis and to 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.