Issuers offer commodity-linked notes with a twist: complex structures tied to a single asset

By Emma Trincal

New York, Sept. 23 - Amid a strong commodity market, issuers are announcing complex structured products linked to the price of one commodity, such as gold or oil, instead of deals linked to a basket of exchange-traded funds or indexes or those with simple structures, as has been traditionally done.

More transparent

"It adds some level of clarity to what you're purchasing," said Art Black, president of BBR Partners, a New York boutique private wealth management firm, referring to the direct link to a single commodity. Blake said that he is familiar with structured products even though he does not typically offer them to his clients.

"There's been a lot of press about ETFs that don't correlate exactly to the underlying. Investors have complained that the ETFs don't move in the direction they should be moving to. So linking a note directly to the price of a commodity addresses this risk of tracking error. In that regard, it's an improvement."

Blake said that in general though, he does not believe in structured products because it's "very difficult to make money in it" and "you're paying too much."

Oil rush, gold rush

Among the recently announced or priced deals are structures put together by Credit Suisse, JPMorgan Chase & Co. and HSBC USA Inc.

Credit Suisse plans to price 15.4% annualized reverse convertible notes due Dec. 31, 2009 linked to the price of West Texas Intermediate light sweet crude oil, according to an FWP filing with the Securities and Exchange Commission.

The three-month notes will pay a coupon of 3.85%. Interest will be payable at maturity.

Payout at maturity will be par unless the price of crude oil falls below the knock-in price - 75% of the initial price - during the life of the notes and finishes below the initial price, in which case the payout will reflect par minus any decline of the price. Investors are fully exposed to any decline in the price of oil beyond 25%.

The issue is expected to price on Sept. 25 and settle on Sept. 30.

JPMorgan Chase & Co. priced $17.55 million of 0% market plus notes due March 23, 2010 linked to the price of gold, according to a 424B2 filing. With this note, the payout at maturity will be par plus the percentage change in the price of gold from the strike level to the final level if the trading price of gold declines from the strike level by 13% or more during the life of the notes, the. Otherwise, the payout will be par plus the greater of the gold return and the contingent minimum return of 5%. In both cases, the payout is subject to a maximum return of 10%.

Another gold deal is coming from HSBC USA Inc. The bank plans to price 0% knock-out buffer notes due March 30, 2010 linked to the price of gold, according to an FWP filing. A knock-out event will occur if the price of gold falls by more than the buffer amount of 13% during the life of the notes. If a knock-out event occurs, the payout at maturity will be par plus the any return on the price of gold, subject to a maximum return of 15% to 22%. The exact cap will be set at pricing. Investors are exposed to any losses. If a knock-out event does not occur, the payout will be par plus the return, with a floor of par plus the contingent minimum return of 5%. The notes will price on Sept. 25 and settle on Sept. 30.

A bid for novelty

Those deals have the same characteristic of offering access to a single commodity through a complicated structure.

"I think it's issuers trying to be creative and increase their market shares by coming up with new underlyings. I don't think there is anything more to it," said Tony Proctor, president of financial planning firm Proctor Financial in Wellesley, Mass. "Everything has been done. They're just trying to pick up something new to do."

'Why?'

Commenting on the three-month Credit Suisse reverse convertible notes, Proctor said: "I don't really see a big market for that note. Why would someone want to buy it?

"If someone is bullish on oil, then why not buy the commodity? And if they're indifferent to the price of oil, why would they want to expose themselves to so much possible risk for a return that's not that tremendous?"

The value of protection

Issuers may have to come up with new structures because they need to accommodate a growing demand for commodity-linked products. Sparked by the surge of some commodity prices, in particular gold, investors have been rushing into commodities this year, market participants said.

"We're seeing a lot of new money coming into commodities, especially through structured notes," said Iain Armitage, who runs global sales and structuring for structured products linked to commodities at Citigroup in London.

He said that most of Citi's institutional clients have currently allocations of about 1% to those products and that they intend to raise this allocation percentage to 5% to 6% this year.

The appetite for commodities is strongly growing among retail investors as well, Armitage added.

However, given the volatility in the commodity market, issuers offering principal protection features may be more successful in pricing their deals than those who don't. The S&P GSCI index, which tracks the performance of commodities, is only up 5.26% year-to-date. But the year saw exceptional index spikes during short periods of time. For instance in May alone, the index surged by 20%.

"The commodity market is mirroring the recovery and we're in full blown recovery mode right now," said Gabriel Burstein, global head of asset management research at Lipper, a Thomson Reuters unit. "But it's still unstable. which is why those principal-protected instruments are in great demand."

J.P. Morgan Securities Inc. is the agent for all three deals discussed above, the Credit Suisse, JP Morgan and HSBC notes.

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