A Financial Feast: A-la-Carte Commodity Investing

The current commodity boom is underpinned by global growth, rampant demand from the BRICs – the newly industrialised countries, primarily Brazil, Russia, India and China – underinvestment in exploration, diminishing stocks and long lead times for the development of new projects. This potent cocktail of positive factors has led to an explosive rally in commodity prices, which has been further fanned by investors pouring money into commodity investments via conventional and new products. The latter have been designed to attract a different universe of investors by offering investment products that do not require specialist commodity knowledge and customized products tailored to meet the precise investment objectives of institutional and individual investors.

Institutional Investors Prefer Commodity Indices…

The best example of this evolution is the widespread acceptance of commodity indices by mainstream investors. These indices have played a key role in ‘securitizing commodities’, effectively transferring them from the physical to the paper world – a transformation that has enabled commodities to emerge as a separate asset class, positioned to compete with equities and bonds for investor dollars.

This success is demonstrated by an estimated $85 billion tracking the two primary indices – the GSCI and the DJ-AIG Commodity Index – up nearly $70 billion over the past three years and growing by approximately $25 billion a year.

…While Equity Investors Like ETFs…

Another excellent example of the securitisation of commodities is the successful launch of a series of gold and silver Exchange Traded Funds (ETFs) in a variety of financial centres. ETFs have also proved to be very popular with equity investors, who have chosen to buy gold and silver via their stock broker, rather than going to the trouble and expense of opening a futures account or locating the nearest bullion dealer. Once again, the success is demonstrated by a whole new class of investors who have, to date, purchased 16 million ounces of gold and 65 million ounces of silver through these instruments. Having unleashed institutional investor demand for commodity indices and equity investor demand for ETFs, financial institutions have not neglected the bond investors: they have tapped into this market by reconfiguring their medium-term note programs to appeal to a broader universe of investors by linking the note coupon to the performance of an underlying investment product.

…And Bond Investors Favour Structured Notes

Over the past 10 years there has been an explosive growth in structured notes, with redemptions linked to the performance of all types of instruments, including equities, rates, and baskets of currencies. Over the past couple of years the spotlight has shifted to commodities and there has been a proliferation of structured commodity notes designed to appeal to bond investors who are attracted to commodities.

Key Drivers: The Three Ps

Structured note holders are typically driven by three key considerations when contemplating a structured commodity note: principal protection, participation and product customisation.

Principal Protection – Unlike commodity indices and ETF investments, structured notes are typically principal-protected products that appeal to bond investors. They are issued in conjunction with a financial institution’s medium-term note program and in almost all cases offer principal protection. The majority of notes protect 100% of principal – provided the note is held till maturity. In some cases, investors settle for less than 100% principal protection in order to boost the coupon return, but protection rarely drops below 90%.

Participation – Investors forgo interest income and, sometimes, some principal protection in order to benefit from a coupon linked to an underlying investment. At its simplest, in the case of a gold bull note, at maturity the investor receives a coupon if the price of gold is higher than it was on the issue date (and no coupon if it is lower).The issuing bank hedges its potential coupon obligation by purchasing a gold call option with the present value of proceeds from the unpaid dollar interest on the principal invested.

The participation rate is a key variable in the decision-making process. A 100% participation rate tends to be the benchmark and is considered to be attractive for gold and means the investor will benefit by 1% for each 1% the underlying commodity price changes between inception and maturity. For example, assume that at inception of a structured gold bull note with 100% participation, the gold price is $600. At maturity, if the gold price has risen to $750 (a 25% rise) the investor will receive a 25% coupon.

Whereas an uncapped note gives the holder of a bull note unlimited participation in an increase in the underlying commodity price, with a capped note the benefit is limited to the level of the cap.

Customised Products – Unfortunately, it is not currently possible to achieve 100% participation for USD-denominated gold bull notes with terms of five years and under, as can be seen from Table 1.

Participation rates vary from commodity to commodity. The participation rate for a bull note is determined by the cost of purchasing an “At the Money Spot” (ATMS) call, which is expensive in gold and cheap in copper. Since gold forwards trade at a premium to the spot price, gold call options are relatively expensive, as they contain intrinsic value. This is not the case for copper, where forwards trade at a substantial discount to the spot price and there is no intrinsic component in the ATMS copper-call premiums. Consequently, copper bull notes will inevitably offer higher participation rates than gold notes.

Creating a Structured Commodity Note

Qualified investors with several million (or more) to invest in a single note can work directly with a financial institution to create a note that exactly matches their investment criteria. They specify a wide range of criteria:

• Issuer rating
• Principal protection
• Duration
• Underlying commodity / commodities
• Bull, bear or range note
• Capped or uncapped
• Additional features.

The financial institution models a note with the specified characteristics from the above list and reverts to the investor with a payout formula. If the payout formula fulfils the investor’s investment objective, the note is launched. Institutional investors and high-net- worth individuals command the maximum structuring flexibility.

Qualified investors who do not have sufficient funds to launch their own customised note have to sift through myriad indicative term sheets to identify a note with suitable investment characteristics. They indicate their investment interest to the structured note sales team, which pools interests from various investors. When a critical mass of interest (approximately $5 million) in a particular term sheet is reached, the note will be launched.

A Four-Year ATMS European Call on a Commodity Basket Quanto Euro Medium-Term Note (and Other Basket Notes)

Participation rates can be improved by creating baskets of commodities, each component of which is in backwardation and is not highly correlated with the others. Baskets may contain combinations of base, precious and energy products. Although the various commodity sectors have recently become more correlated as practically all prices are rising together, the basket notes still offer higher participation rates, as correlations are never perfect.

For example, DrKW recently structured a four-year ATMS European Call on a Commodity Basket Quanto Euro Medium Term Note. The payout is based on the performance of an equally weighted basket composed of Brent Crude Oil, London gold bullion, and LME aluminium, zinc and copper. It is an uncapped note with 100% principal protection and 100% participation. The Quanto feature enables the investor to buy a euro-denominated note and receive the coupon in euros at a fixed exchange rate set on the transaction date with a payout based on the USD performance of the commodities.

Commodity Linked Sales 2006 By Product

Structured Commodity Notes – Market Size

Clearly, the flexibility and attractive payout profiles of these products have attracted a lot of interest, but the amount of investment is difficult to quantify, as not all notes are in the public domain. It is reasonable to assume that at least one USD billion worth of notes has been issued this year.

According to mtn-i data, Commodity Linked MTN Sales have raised USD548m equivalent across seven currencies. While they have identified nine gold-linked tickets, gold is often employed in basket structures, which will account for the majority of Commodity Linked sales this year.

To Keeping the Bears at Bay

Clearly base metals, commodity indices and oil notes are very popular and there has been a proliferation of notes launched with very attractive participation rates.

The low participation rates in gold notes have resulted in relatively modest interest in structured bull notes, though we had been seeing some interest in gold-range accrual notes. For these products, the investor selects a price range (say $600 to $700) and receives an enhanced coupon if the price remains within that range for the note duration.

For example, an investor could buy a one-year $5 million note with a 12.5% coupon if the price remains within the range ($600 to $700) for every observation. Observation is daily and the payout = maximum coupon (12.5%) * no. of days in range / total number of observation days. If the price is outside the range on every observation date, the coupon is zero. Given current US rates of 5%, if the note spends more than 40% of its time in range it outperforms the “risk-free rate of return”. Therefore, the buyer has to believe gold is going to be range bound and, given the recent price volatility, interest in these has slowed.

In the future, when sentiment changes, there could be a lot of interest in gold bear notes, as participation rates are very attractive due to the gold forward curve structure. At which point, investors will be snapping up gold bear notes and disdaining base metal notes whose participation rates will be low by comparison.

In conclusion, over the past few years the commodities investment world has been opened to a new universe of institutional, equity and bond investors. They have seized this opportunity and feasted on products that enabled them to participate in the Bull Run. Let’s hope this boom continues for several more years to come, and that we don’t have to cater to the Bears in 2007!