Bank of the West introduces use of S&P GSCI Dynamic Roll index with new variable income CDs

By Emma Trincal

New York, Aug. 17 - Bank of the West's upcoming market-linked certificates of deposit linked to a basket of S&P GSCI Dynamic Roll sub-indexes represent the first use of a relatively new index created earlier this year to enhance the returns of the S&P GSCI commodity benchmark.

The product is being sold to traditional CD buyers as a way to potentially outperform traditional CD yields and provide diversification from the equity-based CDs that dominate this market, sources said.

"It is the first such time a structured product offering uses a new dynamic roll version of the widely known S&P GSCI Commodity index," a market participant said.

Bank of the West will issue contingent variable income market-linked certificates of deposit due Aug. 30, 2017 linked to a basket of 10 S&P GSCI Dynamic Roll sub-indexes, according to a term sheet.

Interest will be the greater of the average of the basket index performances and zero, payable annually.

If an index's return is positive or flat, its performance will be fixed at 7.5% to 10.5%. The exact fixed percentage will be set at pricing. Otherwise, the performance will be the greater of the return and negative 20%.

The payout at maturity will be par.

New technology

The S&P GSCI Dynamic Roll index, created in January, was the first dynamically rolling commodity futures index to be offered by an independent index provider, said Michael McGlone, senior director commodities at Standard & Poor's.

"Employing a flexible monthly futures contract rolling strategy, the index is designed to meet the demand of investors seeking to alleviate the negative impact of rolling into contango and potentially limit volatility exposure to the commodity market," he said.

The next product to possibly use this underlying could be an exchange-traded note or an exchange-traded fund, he said.

"We see a lot of interest around the launch of an ETF or an ETN," he said.

In a sign that a dynamic roll formula to enhance the returns of a commodity benchmark is gaining traction, Dow Jones Indexes and UBS Investment Bank announced earlier this month the launch of their own version of this concept with the Dow Jones - UBS Roll Select Commodity index based on the Dow Jones - UBS Commodity index.

A distributor said that demand for the CDs is picking up.

"It's definitely a new product," he said. "It's an innovative index. There's no such thing out there.

"Barclays for instance is marketing some CDs that are also linked to a basket of S&P GSCI sub-indexes. "But they're using the standard benchmark, not the enhanced version of the index."

For the market participant, the CDs are a way to enhance returns for investors that have S&P GSCI index exposure.

Rather than using all 24 sub-indexes that comprise the S&P GSCI Dynamic Roll index, Bank of the West's parent company, BNP Paribas, reduced the number of sub-indexes to 10 when structuring the deal.

"I assume they're trying to boost returns. They chose their own commodities, which they believe will outperform. It's a tactical play," an industry source said.

Anti-contango

The key advantage of the Dynamic Roll index versus the S&P GSCI original benchmark is that it reduces the cost of rolling futures contracts, a negative aspect of commodities investing in general, said the market participant.

"There's been a lot of stories about the contango effect. If you look at some ETFs or mutual funds, they very often underperform the movements in the commodity index," he said.

"The way you track commodities is by rolling futures contracts, and in some markets, it can be a costly proposition."

The futures curve is a hypothetical curve created by plotting futures contract prices for a particular commodity, according to the term sheet.

When longer-dated contracts are priced higher than the nearer contract and spot prices, the market is in "contango." It is evidenced by an upward sloping futures curve, which illustrates the negative roll yield.

Higher-priced near-term futures contracts are sold to buy lower priced longer-dated contracts, which erode returns.

Using the same commodities of the index with the same weighting but simply rolling the contracts differently makes a difference in terms of performance, the market participant said.

From January 1995 to January 2011, the back-tested returns of the Dynamic Roll version of the S&P GSCI commodity index outperformed the traditional index by 965 basis points, McGlone said.

One year will do

One of the risks stressed in the term sheet, though, is that investors may get "uncertain" or even "zero interest payments" and that the interest is subject to a cap.

"Compared to a one-year traditional CD for instance that will yield 50 basis points, you have an opportunity to do much better even if your coupon is not a guarantee every year," the market participant said.

"These are for investors who want safety of their principal. They're not going to buy the S&P 500; they're not buying leveraged notes," the market participant said.

"You don't have to generate positive performance every year. If you get two years at the auto-cap out of six, that's 7.5% twice, or a 15% total return. That's pretty good compared to the plain vanilla CD."

The distributor said that demand for the CDs is emanating from clients rolling over their traditional CDs.

Long-term hedge

Another benefit for investors is the underlying asset class itself.

"CD buyers want diversification from equity," the distributor said. "The majority of CDs are tied to baskets of stocks.

Protection against inflation, seen as a risk in the mid-term even if it's not an immediate concern, also may drive interest in the product, the market participant said.

"It's a nice thing to get exposure to commodities. You can hedge against inflation. It's a six-year product. That's the rationale," he said.

The 10 index components that comprise the underlying basket are the S&P GSCI Cocoa Dynamic Roll Index Excess Return, the S&P GSCI Copper Dynamic Roll Index Excess Return, the S&P GSCI Corn Dynamic Roll Index Excess Return, the S&P GSCI Cotton Dynamic Roll Index Excess Return, the S&P GSCI Lead Dynamic Roll Index Excess Return, the S&P GSCI Nickel Dynamic Roll Index Excess Return, the S&P GSCI Silver Dynamic Roll Index Excess Return, the S&P GSCI Sugar Dynamic Roll Index Excess Return, the S&P GSCI Wheat Dynamic Roll Index Excess Return and the S&P GSCI Zinc Dynamic Roll Index Excess Return.

The CDs (Cusip: 06426XBR0) will price on Aug. 25 and settle Aug. 30.

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