UBS links floating-rate note to CPI; inflation uncertainty keeps product volumes low, distributor says

By Kenneth Lim

Boston, Dec. 15 - Inflation-linked products have seen volumes slip along with the rest of the structured products market amid uncertainty about where prices are headed, a distributor said.

UBS AG recently launched a series of principal-protected floating-rate notes due Dec. 31, 2011 linked to the year-on-year change in the Consumer Price Index, the first inflation-linked product in some time.

The notes will pay a monthly interest based on an annual coupon that will equal the CPI year-on-year change plus a spread of 3.25% to 3.75%. The monthly interest will have a floor of zero.

At maturity, investors will receive par.

Uncertainty also hits inflation

The structured product market has seen a slowdown across the board amid confusion about the markets' directions, and inflation-based offerings have also been affected, the distributor said.

"At the start of the year, everybody was worried about inflation, oil prices were shooting up and commodities were going crazy," the distributor said. "Now, oil prices and commodities are in a freefall and the Fed and everyone is now scared of deflation. It's been one hell of a year. In January, if you'd asked anyone if they were afraid of deflation, nobody would have said yes. Now deflation is the new boogey man."

The uncertainty makes it tough for issuers and investors alike to add volume to the market, the distributor said.

"For the issuer, the problem is knowing what the market wants and knowing how to price the products," the distributor said. "For investors, if they don't have confidence in any view, they won't make an investment."

Inflation hedges

Inflation-linked products are generally used to hedge against inflation, the distributor said.

"If you're talking about a floating-rate note, generally the way it works is if inflation is high, you add the inflation rate to your coupon, so that your return also increases as inflation increases," the distributor said.

"But if inflation is low or negative, your coupon is reduced, which means you could underperform straight bonds. It's not surprising that when expectations of inflation are high, you will see more inflation-linked notes being offered. Now, you're less likely to see them just because the threat of deflation or disinflation are higher."

In a deflationary environment, bearish products could see better interest, the distributor said.

"I think the question is, what happens if there's deflation?" the distributor said. "You might see better interest in notes that are bearish on interest rates. Bear notes on many sectors and indexes, retail, consumer goods, those could do better."

The structured product industry will have products for investors whatever the inflation outlook, but whether investors are ready to invest is another issue, the distributor said.

"In theory, whatever the market, we as the structured products industry have something to offer to investors," the distributor said.

"I think it's been said many times before, but what we're seeing now in terms of the slowdown in investments and the lack of capital is part of a bigger phenomenon of uncertainty and risk aversion in the markets that we're not totally in control of, so yes, we can still offer solutions to investors, but we need to convince investors that our solutions are what they need at this time."

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