Hedge World reports about commodity-linked notes drawing more investors.
(emphasis mine) [my comment]
Commodity-Linked Notes Drawing More Investors
By Jacob Bunge, Financial Correspondent
Monday, July 14, 2008
LONDON (HedgeWorld.com)—Retail and institutional investors alike are piling into commodity-linked structured notes according to the firm MTN-I, even as overall sales of structured notes declined.
Sales of commodity-linked notes rose to $15.8 billion over the first half of 2008, up from $7.8 billion over the same period a year ago, according to MTN-I, which is a data and news provider for private placement and structured fixed-income markets. Reported deals numbered 648 over the six months ended June 30, as opposed to 463 the year before.
Over that same period, however, overall global structured note sales fell by about 20%, to $227 billion. MTN-I officials in a report ascribed the decline to lower demand for notes linked to rates and equities, the biggest underlying asset classes.
Structured notes are fixed-income securities in which the payoff is linked to the performance of an underlying asset or derivative, providing investors a means of principal-protected or leveraged exposure to asset classes such as commodities, according to MTN-I. When it comes to commodities, such notes often have the coupon or redemption benchmarked to a commodity index, a basket of commodity prices or a single price.
Others have noted the rising popularity of structured notes as a means of accessing commodities markets. In May Greenwich Associates released a report showing that 21% of commodities investors used structured notes based on commodity derivatives, with banks as the most common users Previous HedgeWorld Story.
In terms of volume, the most popular commodity-linked structured note products among retail investors are those offering exposure to commodity indexes such as the Standard & Poor's Goldman Sachs Commodity Index, the Dow Jones-AIG Commodity Index or the Rogers International Commodities Index.
Among institutional investors, broad commodities market benchmarks are popular as well, along with specific commodity exposure linked to sectors like natural gas and wheat, according to MTN-I officials. Some institutions also are using structured notes to access more esoteric markets—Morgan Stanley developed a series of products linked to the Baltic Dry Freight Index, while Barclays Capital has a product for German electricity prices. Other banks offer structured notes for carbon emissions.
Overall about 62% of commodity-linked structured note sales in the first half of the year were linked to proprietary indexes, with 25% linked to commodity indexes. More than 9% were linked to gold, with approximately 2% linked to baskets of commodities. A smaller number tracked gas and oil.
About 77% of all commodity-linked structured notes sold so far this year were issued by investment banks. MTN-I's research showed Deutsche Bank leading sales in the first half of 2008, with 59% of all sales. Barclays was second with 13% and Credit Suisse third with 5%. Merrill Lynch, across various entities, represented a little over 5% of sales.
Investors' enthusiasm for commodities exposure contributed to higher demand for similar notes linked to foreign exchange and inflation, according to MTN-I. In the United States, sales of FX-linked products climbed to $4.3 billion over the last six months, up from $2.8 billion a year ago, with investors seeking exposure to BRIC currencies as well as the Australian dollar. With energy, agriculture and precious metals hitting records over the past six months, inflation-linked note sales saw enormous growth, hitting $895 million in the first half compared to $35 million in the first six months of 2007.
Sales of interest-linked structured notes came in around $91 billion for the first half of 2008, down from $121 billion last year, and equity-linked notes were at $89 billion, down about $7 billion from the same period in 2007.
Futures Industry reports about mutual funds tapping into commodities.
Mutual Funds Tap Into Commodities
by Neil O'Hara
It's no secret that commodities are hot. Whether it's energy, metals or agricultural products, most prices are either near record highs or at levels not seen for a generation. Now retail investors are clamoring to get in the game. Most investors don't have a futures account, however, and in any case would rather get commodities exposure through a diversified pool. As a result, retail investors have piled into a new class of mutual funds that track commodity indices, a simple way to get a broad portfolio in a familiar format.
"People are first enticed by the high recent returns but when they dig a little deeper they realize it's generally uncorrelated with whatever they currently have," says Jim King, director of portfolio management at Baltimore- based Rydex Investments. "Risk mitigation through diversification is the real story."
Ironically, just as these funds are achieving broad recognition, a tax ruling from the Internal Revenue Service has forced them to change the way they obtain their exposure to the commodity indices and temporarily put their marketing efforts on pause. Instead of using commodity swaps, the funds are turning to commodity-linked structured notes, and in at least one case, going directly to the futures markets.
The trend first started in 1997, when Oppenheimer launched its Real Asset Fund. Pimco, one of the biggest names in bond investing, joined the trend in 2002, when it launched its Commodity RealReturn Strategy Fund. Today there are at least eight of these funds offered to retail investors by some of the largest names in the mutual fund business, with approximately $15 billion of assets under management. By way of comparison, that is more than 10% of the money invested in the managed futures business, which includes both institutional and retail money.
Except for the Oppenheimer fund, these funds generally do not invest directly in futures. Instead, they use over-the-counter derivatives based on commodity indices. These indices track a basket of futures on physical commodities, following rules set by the index p roviders that remain constant over time. The two most commonly used are the Goldman Sachs Commodity Index and the Dow-Jones AIG Commodity Index.
Unlike a commodity pool or a hedge fund, there is no trading strategy or active selection process. The basket may be adjusted from time to time to maintain the component weightings, but that is the job of the index provider. The funds simply buy and hold the index, much like the large number of funds based on equity indices such as the Standard & Poor's 500.
Oppenheimer's Real Asset Fund is a little different. Although it pays homage to the Goldman Sachs Commodity Index, it does not purport to track it precisely. The fund holds approximately a third of its assets in structured notes that are linked to the GSCI. These notes are typically leveraged three times, so the fund can get full portfolio exposure by putting up only one third of its assets. In addition, the portfolio includes substantial direct holdings of futures contracts and options on futures as well as structured notes and other commodity-linked derivatives. As of March 31, 26% of the Real Asset Fund portfolio comprised energy futures—crude oil, natural gas and refined products—with another 5.7% in metals and agricultural futures.
Components of Return
The returns generated by these funds come from three sources. The first two come from the way that these indices are constructed. Not only do they increase in value when commodity prices rise, and vice versa, they also reflect the roll return, that is, the return from selling the futures contracts in the basket as they approach the expiration month and buying the same contracts in a deferred month. Each index has different rules for when and how the contracts are rolled forward, and this has an important impact on returns.
The third source of returns for these funds comes from cash and collateral. If one looks at the portfolios of these funds, one sees that the largest holdings have nothing to do with commodities [I actually noticed this when looking at Pimco's fund. I though about doing an entry on it at the time]. Instead, the bulk of the fund assets are money market instruments or shortterm notes. Since these funds are using derivatives to obtain their exposure to the commodity indices, only a small amount of the customer funds are needed as collateral to support the investment strategy. The remainder can be invested in overnight repurchase agreements, treasury bills and the like.
This creates an opportunity to enhance the returns on the index. Oppenheimer's fund, for example, actively manages its collateral as a short-term bond portfolio (most mature within 12 months) that earns a higher yield than money-market instruments. Pimco leverages its bond expertise by investing the cash in its Commodity RealReturn fund into an actively managed portfolio of fixed income securities, including inflation-linked bonds issued by the U.S. Treasury. In this way, Pimco's fund makes investing in commodities even more attractive to retail investors concerned about rising inflation, although its "double real" strategy carries the risk that returns on the fixed income investments might fall below the returns on cash.
Although the funds' exposure to commodities is indirect, their buying power still shows up in the futures markets. When the major derivatives dealers —Goldman Sachs, Barclays Capital and AIG Financial Products among them—sell over-the-counter commodity- linked derivatives to the mutual funds, the dealers end up short. To hedge their book, dealers turn around and buy enough futures to flatten their position. Everyone gets what they want: investors get diversification through a familiar vehicle, mutual fund companies increase their assets under management, derivatives dealers earn fees by replicating the index, and the futures industry benefits from higher trading volume.
The Move into Structured Notes
Last December, however, the Internal Revenue Service threw a monkey wrench into the operations of these funds. It ruled that income from commodity-linked swaps did not meet its test for "qualifying income" because the underlying instruments were not securities. As a result, a mutual fund that relied on commodity swaps for more than 10% of its gross income would lose its status as a registered investment company, and thereby become subject to an assessment on their taxable income and capital gains, rather than passing them through to their investors.
The ruling will not take effect until July 1, but it had an immediate impact. Pimco, whose fund relied primarily on commodity swaps, said in December that it was "both shocked and disappointed" by the ruling, and said it would "explore a range of legislative and regulatory alternatives that would expand the set of investment techniques" available to its portfolio manager.
In the meantime, the funds are scrambling for an acceptable alternative to swaps. The same IRS rules that disqualify commodity swaps as "qualifying income" also apply to commodity futures, so the funds can't just replicate the indices themselves with the component futures contracts. As a result, the most attractive alternative, according to investment industry experts and the funds themselves, are structured notes that deliver a return linked to a commodity index.
Like swaps, structured notes are over-the-counter instruments issued by investment banks and other counterparties. They tend to be slightly more expensive than swaps, but they can qualify as debt securities in the eyes of the IRS as long as they meet a "facts and circumstances" test, according to tax experts. There is no bright line standard, but they have to have a fixed term and offer some degree of principal protection, meaning that some portion of the principal is returned to the investor when the note comes due. In other words, if the notes look and feel like a debt instrument, they should pass muster.
Meanwhile, the IRS ruling has chilled asset inflows as the fund managers scramble to restructure their portfolios before July 1. Pimco, for example, had obtained $5.4 billion of commodity index exposure through structured notes as of April 7, according to an update posted on its web site on April 11. Not all of the funds are facing this problem; the Oppenheimer fund, the second largest, relied primarily on structured notes even before the IRS issued its ruling. But even Oppenheimer has felt the effects. The fund closed its doors to new money effective April 28 "in order to preserve the benefits of the fund's strategy to current investors." When it announced the move, Oppenheimer hinted at capacity constraints in the structured notes market, blaming "the current availability and environment for commodity-linked instruments."
The uncertainty hangs like a sword of Damocles over commodity mutual funds. "A lot of money has decided to sit on the sideline and let this whole thing work itself out," says Rydex's King. Like Pimco, his firm plans to switch from swaps to structured notes, relying on a private letter ruling it received from the IRS in April.
According to the letter, each note will have a term of a year and a day, but the fund has the right to put the note back to the issuer on one day's notice. The notes also have a "knockout" feature that requires the fund to repay the note one day after the reference index drops more than a predetermined percentage. The amou nt payable upon early redemption, knockout or at maturity equals the face amount of the note multiplied by the percentage change in the reference index through the payment date, plus a fixed-rate coupon amount, less an annualized fee. The index-related payment and the fee will both increase proportionately if the fund uses leverage. Rydex has not disclosed the knockout threshold, the coupon rate nor the fee, but the IRS ruled that the proposed note qualifies as "a hybrid instrument that is predominantly a security" not subject to the Commodity Exchange Act. Any income or gain a mutual fund receives from the note will therefore constitute qualifying income, which will preserve the fund's tax status.
Although the market for commoditylinked structured notes is not as mature as swaps, King expects that will change in short order. "I think a lot of the mutual fund industry will migrate to structured notes as their vehicle of choice," he says. "As a result, the pricing structure and liquidity will improve rapidly."
In effect, the switch to structured notes will be a triumph of form over substance. Keith Styrcula, chairman of the Structured Products Association, explains that one way a note issuer can hedge its commodity exposure is through a total return swap with either its own swaps desk or a third party. The counterparty will then lay off the risk in the futures market. "At the end of the day, much of the hedging winds up creating open interest and volume in the underlying futures contracts. All roads lead to enhanced liquidity on the futures exchanges."
An obscure tax ruling won't dampen investors' enthusiasm for commodities, anyway. Although mutual funds are convenient and familiar, investors do have other choices. In the last 18 months, exchange traded fund sponsors have moved into the commodities arena with ETFs that track the price of gold, oil and silver. Competition may pose a bigger threat to commodity mutual funds than the IRS as commodity-linked vehicles open to retail investors proliferate.
Cattle Network reports that commodity structured notes market hurt by credit crisis.
FOCUS: Commodity Structured Notes Market Hurt By Credit Crisis
LONDON (Dow Jones)--Risk-averse investors have cooled significantly on a bond-like product that follow the prices of various commodities.
Known as commodity structured notes, the instruments are sold by financial institutions and can be tailored to the specific demands of customers. They enjoyed strong demand during the commodities boom, but they've become the latest victims of the widening fallout from the credit crisis.
Typically, the notes are designed by financial institutions to outperform benchmarks such as commodity indexes or individual commodity futures, and can provide various levels of risk, with some offering full capital protection. Maturities customarily run from less than one year to a maximum of five years.
Industry watchers said institutional investors have either withdrawn temporarily from the market or are buying options in the over-the-counter market, which puts less of their money at risk. And with the turmoil that's engulfed U.S. investment banks, there are fewer of them around to offer the products.
"At the moment, there is little appetite for risk," said Jose Ortiz, head of European pricing in the commodities division of JP Morgan. "We are seeing that clients are paying a lot of attention to who is behind the note." [They probably aren't accepting any more of these notes from AIGFP]
Commodity structured notes had been particularly popular in Europe, where institutional investors had begun shifting toward them instead of seeking passive long exposure to commodity indexes.
But that trend has been arrested for the moment, reflecting widespread concern over the solvency of financial institutions issuing the notes and waning confidence in commodity returns.
Barclays Capital, one of the leading note issuers, estimates over $6.5 billion worth of commodity-linked structured notes were issued in the first half of 2008, up from just under $550 million for all of 2006.
In a report last week, the investment bank said demand for commodity structured notes in the third quarter actually increased overall. Gold-linked products led the way while agriculture-linked notes slowed.
But those in the industry said a more accurate reflection of what's happening will come from fourth-quarter figures, because it was only in September that the credit crisis unspooled into a global financial and economic crisis.
Typically structured notes are unsecured, which puts buyers at risk if issuers go into bankruptcy. That wasn't a concern of most institutional investors until the events of this fall. The bankruptcy of Lehman Brothers, however, quickly left buyers on the hook and possibly unable to recoup their capital.
Other troubled financial institutions that have issued commodity structured notes include insurance giant American International Group (AIG), UBS AG (UBS), Morgan Stanley (MS) and French bank Dexia (HIB4.BE).
"This counterparty credit quality is the paramount issue right now," said Eric Kolts, director of commodity indexes at Standard & Poor's. "The number of products offered by investment banks is probably going to be shrinking."
Kolts said most investors who are still buying structured notes are demanding ones that offer guarantees against bankruptcies. "Investors are willing to give up the upside to get capital protection."
JP Morgan's Ortiz said investors are buying over-the-counter options rather than structured notes because the latter require buyers to deposit the full value, also known as the notional, with the issuer. "(They'd) rather pay the 5% option premium. If you're paying the notional, your putting the full capital at risk," he said.
One sign of how difficult the times are for structured notes is the closure of U.S. money manager BlackRock Inc.'s (BLK) $32 million commodity fund BlackRock Commodity Strategies Fund (MDCDX). The fund was launched in 2004, but is being unwound because there are fewer note issuers and the smallest notes being offered now are $5 million.
Given the fund's relatively small size, notes of that magnitude put a disproportionately large amount of capital with one counterparty fund, said spokesman Brian Beades. "At $32 million, the size of the fund had restricted the portfolio management team's ability to effectively execute on the fund's investment strategy."
Normally, the notes have been unsecured, but some investors may now seek to have them secured so they can recoup their capital in the event of an issuer's insolvency. Ronan O'Connor, head of risk and asset allocation at the Irish National Pensions Reserve Fund, said the pension fund had four structured notes, one with Lehman Brothers and another with AIG.
O'Connor said the fund had believed the counterparty risk involved in purchasing the notes had been manageable, but have obviously been proven wrong. In the future, the fund will opt for secured notes, he added.
JP Morgan's Ortiz said he was optimistic that greater stability in equity and credit markets would reinvigorate demand for commodity notes. "It's premature to draw conclusions. These conditions can't last."
AIGFP funds itself, in part, by issuing commodity IOUs. AIG admits as much in its 2007 annual report.
AIGFP uses the proceeds from the issuance of notes and bonds and GIA borrowings, as well as the issuance of Series AIGFP notes by AIG, to invest in a diversified portfolio of securities and derivative transactions. The borrowings may also be temporarily invested in securities purchased under agreements to resell. AIGFP's notes and bonds include structured debt instruments whose payment terms are linked to one or more financial or other indices (such as an equity index or commodity index or another measure that is not considered to be clearly and closely related to the debt instrument).
My reaction: Commodity linked structured notes are an insane investment.
1) In 2008, 21% of commodities investors used structured notes based on commodity derivatives, with banks as the most common users.
2) Most "commodity funds" use structured notes and other commodity derivatives.
3) Like swaps, structured notes are over-the-counter instruments issued by investment banks and other counterparties.
4) Nearly all structured notes are unsecured, which puts buyers at risk if issuers go into bankruptcy. The bankruptcy of Lehman Brothers, for example, quickly left buyers on the hook and possibly unable to recoup their capital.
5) Other troubled financial institutions that have issued commodity structured notes include:
A) Insurance giant American International Group (AIG)
B) UBS AG (UBS)
C) Morgan Stanley (MS)
D) French bank Dexia (HIB4.BE).
Conclusion: When the dollar collapses, expect default on all commodity-linked structured notes. These notes are COMPLETELY USELESS as an inflation hedge.
My reaction: Commodity linked structured notes are an insane investment.