Structured Product Analysis: March Structure No. 9 - A Very Bad Buffered Capped Leverage Return Note

by: Reid Guenther

Summary

Detailed analysis of structure No. 9 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. 9 in my March structured products survey. This article should prove indispensable in helping you understand the risks and rewards of that product and why it is expected to be a bad investment.

The Structure

The following table contains the basic information about the product:

The structure is partially principal-protected ("PPP"). The underlier is the iShares MSCI Emerging Markets ETF (NYSEARCA:EEM) 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% with the possible loss of principal dropping in proportion to the underlier's return. Thus, the maximum loss of principal is -90%. Between underlier returns of -10% and 0%, the loss of principal is 0%. A leverage factor of 2.0 is applied to positive returns up to 13% at which point the payoff is capped at 126%. 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, 48128GQC7.

The following graph helps you visualize the payoff logic:

The valuation results shown below are as of the analysis date, 03/11/2016.

As you can see, the estimated issuer price of 99.25% means that the issuer does not have much room to improve the terms of the structure. Unfortunately these terms need improvement. While the historical valuation is just above par at 100.75%, the scenario valuation of 95.89% is the second worst in the March survey. The reason for such poor results is covered in the next section.

The Analysis

This graph shows how structure No. 9 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 emerging market ETF, EEM, 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 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 underlier.

The annually compounded structure discount rate for this product is 3.53%. Thus, the 126% capped payoff actually has a discounted value of 117.56%. The discounted capped payments are easy to pick out in the graph as they form horizontal lines in the payoffs during periods when the market is steadily rising.

The 100% return of principal payment has a discounted value of 93.30%. Those points are the intermittent plateaus, which mainly occur during the period as the EEM was moving sideways over most of the past 6 years.

Losses of principal occur mainly due to the market crash during the financial crisis. But unlike similar products with domestic underliers (e.g. for structures Nos. 5 and 6), those losses reoccur due to subsequent periods of market unrest with many of those losses occurring in the final start year of this historical analysis.

So how does all of this contribute to the historical valuation of the product? That is more easily understood by examining the distribution of the historical discounted payoffs.
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45.5% of the discounted payments are at and above 100%. The payoff cap is easy to pick out as the large spike close to 120%. It dominates the above-fair-value discounted payoffs comprising almost 40% of all the payoffs. The return of principal payments is the spike in the middle. It comprises close to 24% of the total distribution. The loss-of-principal payoffs are not too bad with the minimum about 62% and the majority lying between 80 and 90%. All these contribute to allow the historical valuation of the product to be just above fair at 100.75%.

Now let us see how the scenario payoffs are distributed:
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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 emerging markets ETF over the same period as the historical analysis.

Comparing the scenario distribution to the historical, we see some interesting results. The payoffs at and above 100% increase by over 2% to 47.7% with a similar increase in the capped payoffs. However, the 100% return-of-principal payoffs have dropped by over 10% to around 13% while the loss-of-principal payments have not only increased, the distribution of losses has dropped to include discounted payoffs below 40%. This large increase of loss-of-principal payoffs offsets the above-par payoffs and results in the scenario valuation of 95.89% which, as stated before, is the second worst valuation in the March survey.

In Conclusion

The barely-above-historical valuation and the far-below-par scenario valuation lead to the conclusion that this is definitely a bad investment. The relatively high estimated issuer price indicates there is not much that can be done for the product. In my next analysis, a very similar product is analyzed with even worse results, but as you will see, the issuer does have room to make improvements.

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.