Structured Product Analysis: March Structure No.10 - Another Very Bad Buffered Capped Leverage Return Note

by: Reid Guenther

Summary

Detailed analysis of structure No. 10 from the March survey.

Results detail why this is expected to be an especially 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. 10 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 Russell 2000 (RTY) and the term of the product is 3 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 -15% with the possible loss of principal dropping in proportion to the underlier's return. Thus, the maximum loss of principal is -85%. Between underlier returns of -15% and 0%, the loss of principal is 0%. A leverage factor of 2 is applied to positive returns up to 10.75% at which point the payoff is capped at 121.5%. 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, 06367TBX7.

The following graph helps you visualize the payoff logic:

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

The estimated issuer price of 93.81% means that the issuer has room to improve the terms of the structure. Relative values of 100.80% and 94.93% for the historical and scenario valuations indicate that improvement of the terms are sorely needed as the scenario valuation is the worst of the 16 products surveyed. The reasons for such poor results are discussed in the next section.

The Analysis

This graph shows how structure No. 10 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 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 4.08%. Thus, the 121.5% capped payoff actually has a discounted value of 107.76%. The discounted capped payments are easy to pick out in the graph as they form the horizontal regions in the payoffs during periods when the market is steadily rising.

The 100% return-of-principal payment has a discounted value of 88.69%. You can pick those points out during the three-year period before the market crash starting in late 2008. Losses of principal indicated by discounted values below 88.69% start 3 years before the market crash and continue up to the preceding market peaks.

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.
Click to enlarge
72.7% of the discounted payments are at and above 100%. The payoff cap is easy to pick out as the large spike below 110%. It dominates the above fair value discounted payoffs at over 70% of all the payoffs. The return-of-principal payments is the small spike just below 90%. It comprises less than 7% of the total distribution.

The loss-of-principal payoffs are not too bad, with the minimum at about 54% and the majority lying between 80 and 90%. Even with the large number of above-par-historical discounted payments, the capped level of 107.76% is not high enough to tilt the average discounted payoff much above par and thus, the historical valuation sits at 100.75%.

Now let us compare how the scenario payoffs are distributed and figure out why that valuation is so low.
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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 Russell 2000 over the same period as the historical analysis.

The payoff distribution above 100% has dropped over 18% to 54.3%. The return-of-principal payments have increased over 10% to around 17%. The loss-of-principle payments extend below a discounted value of 40%. This all results in the average discounted payoff dropping well below par to 94.93%. That drop is mainly due to that 18% drop in capped payoffs.

In Conclusion

The just-above-par historical valuation and the very low scenario valuation lead to this product being a very bad investment as was the case for structure No. 9. The issuer pricing does show that they have room to improve the terms of the structure. However, given that the issuer will not issue a product which is not expected to be profitable, it is unclear without further analysis if the terms could be improved enough to make this at least a fair investment.

Well, that is the last of the pure growth products. Next up is one of the more interesting structures as it combines both growth and income features.

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.