Deutsche Bank to sell notes tied to Liquid Commodity Index Optimum Yield: less contango cost

By Emma Trincal

New York, Nov. 16 - Investors seeking exposure to a concentrated basket of commodities without incurring the negative yield created when rolling the underlying futures contracts may use notes linked to a special version of the Deutsche Bank Liquid Commodity Index called - Optimum Yield, an offering of which is set to price next week.

Deutsche Bank AG, London Branch plans to price 0% capped Buffered Underlying Securities due Nov. 28, 2012 linked to the Deutsche Bank Liquid Commodity Index - Optimum Yield, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 150% of any index gain, capped at a maximum return of 29.5% to 36.5%. The precise cap level will be set at pricing.

Investors will receive par if the index falls by up to 10% and will lose 1% for each 1% decline beyond 10%.

Minimizing contango

"The objective of the optimum version of the DBLCI [Deutsche Bank Liquid Commodity Index - Optimum Yield] is to optimize roll returns," said Rajiv Shukla, head of commodity asset structuring at Deutsche Bank in London.

The Deutsche Bank Liquid Commodity Index, established in 2003, tracks six commodities - crude oil, heating oil, aluminum, gold, corn and wheat.

In 2006, Deutsche Bank created the Optimum Yield version of this index, referencing the same commodities but seeking to generate the maximum implied roll yield by selecting from futures contracts expiring at a range of dates.

The Optimum Yield version, according to the prospectus, employs a rules-based approach when rolling from one futures contract to another. Rather than selecting the new contract based on a pre-defined schedule, the index picks the contract that generates the maximum implied roll yield.

According to the prospectus, the methodology seeks to "maximize benefits in backwardated markets and minimize the loss from rolling down the curve in contango markets."

Contango describes a carrying charge market, where commodities destined for later delivery are priced higher than commodities delivered earlier. If the contracts are automatically rolled forward, a cost will be incurred as the sale of the expiring, near-term delivery will be done at a lower price than the cost of buying the deferred contract. Such cost - called rolling cost - eats into the returns garnered by the appreciation in the price of the commodity. A backwarded market is the opposite situation and generally yields more profit.

Deutsche Bank is believed to be one of the first banks to have produced a commodity index aiming to reduce the effects of contango on index returns, said the sellsider.

Deutsche Bank has used the Optimum Yield version of its index a number of times since its creation for the creation of exchange-traded funds and structured notes, said a sellsider. In July and August, Deutsche Bank offered its "Market Notes Appreciation" products, which were notes linked to the Deutsche Bank Liquid Commodity Index. The participation rate was 100%.

Rolling costs are more problematic for passive investors whose returns are tied to the performance of an index. For active commodity traders, it is less of a concern.

"I don't worry too much about the roll. I buy what I think is going to go up. So in this index, I would like corn and wheat, as I think they're going to move higher. Gold is more of a concern as it is a very crowded trade," said Matthew Bradbard, president of MB Wealth.

Adding currencies

The maximum return of the notes will be the cap multiplied by the 150% participation rate, or between 44.25% and 54.75%.

Bradbard said that he liked the payout structure of the notes.

"It's a better return than stocks. It's not bad despite the cap."

However, Bradbard added that his preference would be to have notes linked to a more inclusive basket, including not just commodities but also currencies, as a way to hedge against the risk of further depreciation of the dollar.

"My problem with the basket is that it's commodities only. If the dollar continues to go down, it's going to be less return. I'd rather see a basket that includes commodities, but also the Australian dollar or the Canadian dollar," he said.

ETF alternative

Some financial advisers prefer to build up portfolios using ETFs. Such is the case of Kirk Kinder, financial adviser with Picket Fence Financial.

"I don't see the benefit of a structured note without the total principal protection. That would be the only reason I would do this. You could do exactly the same thing with an exchange-traded fund. An exchange-traded fund is extremely liquid. It has no cap. It's cheaper. And if the trade turns against you, you can sell immediately," said Kinder.

PowerShares DB Commodity Index Tracking Fund used to reflect the exact composition of the Deutsche Bank Liquid Commodity Index, tracking its six underlying commodities. Since last month, however, Deutsche Bank has modified its popular ETF and enlarged it to include eight other commodities for a total of 14.

"There is no ETF that directly tracks the Deutsche Bank Liquid Commodity Index," said the sellsider.

Hard to replicate

Kinder added that the leverage offered in the structured notes can be accomplished directly by the investor at less cost.

"You could leverage your ETF with a margin account. Or you could buy the futures directly. A futures contract is leverage. You only put down 10%. You could create your own mini portfolio with exactly the same commodities."

But it may be easier said than done for retail investors.

"In regards to people saying you can do that with futures, in order to replicate an index through a derivative futures contract, an investor would need to create a basket of the same commodities with a similar allocation using the same contracts, and rolling them in the same manner as the underlying index," said Deutsche Bank's Shukla. "Although it is possible, it is inconvenient to track six and roll them into different contracts."

The notes will price on Nov. 23 and settle on Nov. 27.

Deutsche Bank Securities Inc. and Deutsche Bank Trust Co. Americas are the agents.

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