Structured Product Analysis: March Structure No. 8 - A Good Buffered Digital Return Note

by: Reid Guenther

Summary

Detailed analysis of structure No. 8 from the March survey.

Results detail why this is 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.

The analyzed structured product is structure No. 8 in my March structured products survey. This article should prove indispensable in helping you understand the risks and rewards of that product.

The Structure

The following table contains the basic information about the product:

The structure a growth product which is partially principal-protected ("PPP"). The underlier is the Russell 2000 (RTY) and the term of the product is 3.5 years. The following payoff logic gives meaning to the payment features mentioned in the previous table.

The payoff is buffered by 20% from potential loss of the investor's principal. Losses to the that principal begin below -20% and decrease at the same rate of decrease to the underlier's return. Thus, if the underlier return were to drop to -100%, the investor would lose -80% of their principal. At returns of -20% and up, a digital payment of 121% is made.

Of course, all these payment scenarios assume there is no default by the issuer. Information regarding the issuer's debt obligations in relation to this structure as well as more product details on the structure can be found using the SEC's EDGAR search engine by looking up the product's CUSIP, 22546VXM3.

The following graph helps you visualize the payoff logic:

Now let us focus on the product valuations shown below:

As you can see, the estimate of the issuer pricing shows they have some room to adjust the terms of this structure and still expect to hedge a profit. While that would be good for the investor, it is not necessary to make this product a good investment. The historical valuation is well above fair while the scenario valuation is slightly above fair, thus indicating the product is a good investment. My previous analysis covered structure No. 7 which is very similar to this structure but was found to be a bad investment. The few differences between structure No. 7 and structure No. 8 show how subtle changes in a product can change it from bad to good. I will go over those changes after I go through the details of the analysis which detail why this buffered digital return note is expected to be a good investment.

The Analysis

The graph below 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 Russell 2000 is given to show how its performance relates to the historical discounted payoffs.
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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 the structured product as opposed to investing in the underlying market, which is the Russell 2000 for this case.

The annually compounded structure discount rate is 2.99%. Thus, given the 3.5 year product term, the discounted digital payoff is 109.16% which corresponds to the horizontal lines of historical payments shown in the above graph. The discounted return of the investor's principal is 90.22%. This is important to note as losses of principal will occur at values below that level. As you can see, the losses of principal start about 3.5 years before the market plummets towards the end of 2008. These losses continue for about a year. Only two other investor-loss principal payments occur after that.

The distribution of historical discounted payments shown below reiterates the described payment history while allowing you to understand why the historical valuation is well above par.
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As the legend indicates, 88.4% of the payments are at the digital discounted amount of 109.16%. The remaining 11.6% are scattered between 70% and 90% with the majority being between 80% and 90% of fair value. This results in the historical valuation of 106.49%, which is close to its maximum possible value, the digital level.

Now let us look at the scenario analysis for which 10,000 simulations were performed. These simulations used the same structure discount rate as well as the historical average return and variance of the Russell 2000 over the same historical period. The following graph shows the results.
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The percent of digital payments drops to 77.6% of the total while the remaining 22.4% are shown to span from 90% to below 40%. But the majority of those points lie between 70% and 90%. Not as good as the historical case, but the scenario valuation is still above par at 101.59%.

In Conclusion

The high historical valuation along with the above par scenario valuation lead me to conclude that this product is a good value. The differences that allow structure No. 8 to be a good investment while structure No. 7 is not are the underliers (SPX vs RTY), the buffers (15% vs 20%) and the return at which the digital return kicks in (0% vs -20%). Given the S&P's lower historical variance, if it were used in structure No. 8, I suspect the issuer's value would be close to 100%, and thus they would not issue such a product. Thus, switching to the more volatile Russell 2000 is necessary to allow for the larger buffer and the lowering of the return level at which the structure pays the digital return. Those differences are what allow structure No. 8 to be a good 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.