Derivatives 2005 - Commodity hybrids move centre stage
The search for yield is driving structuring desks beyond cross-asset class combinations such as credit and rate trades towards commodity and energy-linked deals. With money pouring into commodities and existing investors taking more tactical views, the commodity-linked hybrid space is developing quickly. This development presents its own set of risk management challenges. Jean Haggerty reports.
According to some estimates, the first quarter of this year saw more commodity-linked hybrid products sold than all of last year. “The returns [for the commodity sector] are excellent and there is a believable and coherent story for why that should continue. It is not like 1973 and 1979, where [the oil market] was supplying the lead. This is about demand and growth,” said Kevin Rodgers, global head of energy trading at Deutsche Bank (see chart). Most commodity-linked transactions are oil-focused.
The optimal allocation to commodities is widely seen as 5% of a portfolio, but the reality is that many investors have no commodity allocation at all, said Arun Assumall, executive director and head of European commodity investor sales at Goldman Sachs. While the commodity index market is a US$70bn market, the commodity-linked structured products market is estimated to be a US$15-20bn sector.
When it comes to getting exposure in commodities structuring is key. “You have to consider that a lot of investors cannot buy 1,000 lots of WTI futures - that risk would be well outside their mandate,” said Wayne Harburn, global head of commodity derivatives at ABN AMRO.
Because the price of energy as measured by oil in recent years has more than doubled, fixed income payouts have grown in popularity, he noted.
The general trend in commodity-linked products is for more complexity and greater use of the barrier technology that is already widespread in the foreign exchange and equity markets. Goldman Sachs has been in the market with bonus bonds - a structured commodity index product that guarantees a return as long as the underlying does not touch certain barrier – while JPMorgan has turned the oil buffer certificates that it launched 18 months ago into butterfly certificates.
"Many investors are becoming nervous at current oil price levels. While they are still confident that oil will appreciate, they believe the price level is capped at US$85-90 per barrel, so they are prepared to cap their participation at 30% above current levels in return for higher participation and some protection if the oil price falls," said Tim Owens, global head of currency and commodity solutions at JPMorgan.
"It is a popular product because it offers a geared return and an enhanced return protection if oil range trades for a while," Owens added, noting that typical tenors are three to four years.
According to some market participants, the amount of barrier option trades recently executed is worth keeping an eye on. “If we do go near to the barrier level where a lot of barriers have been structured we potentially could get sucked into a liquidity hole - much like we did with large FX barriers in the spring of 1995. The lack of liquidity in the underlying market could make it tricky for dealers to hedge,” said Deutsche Bank’s Rodgers.
As these products have barrier levels on the downside that have been left far behind by the rally in crude, this is viewed as a concern that is unlikely to materialise any time soon, however.
Relative to traditional asset classes, like fixed income or equity, commodities are often viewed as risky. In light of this, applying constant proportion portfolio insurance (CPPI) technology on commodities is an idea that has been floating around the dealer community. CPPI products can offer a way to achieve principal protection by investing in a risky asset class.
The gap risk on CPPIs on commodities can be harder to handle than on CPPIs in other asset classes, however, as the commodity markets can spend years in the doldrums or at plateaus. "This behaviour makes most CPPI strategies look poor performers when they are back tested," Rodgers said. While the stunning returns of commodities in the last two years produce attractive back-testing, the Asian crisis in 1998 and the market downturn in 2001 dampen results.
CPPIs with commodity underlyings are widely regarded as a developing phenomenon. Commodity CPPIs would look no different from other CPPIs in technical terms. Extreme volatility of commodities and the relative lack of liquidity for many hours during the day are what would make structuring a commodity CPPI challenging.
As rising interest rates would be good for commodities and CPPIs work best in a high rate environment, adapting CPPI technology to commodities has a double attraction, said Torsten DeSantos, European head of commodity investor solutions at Barclays Capital in London.
"CPPI is also very complicated and for many clients it is a difficult sell," he said. "However, given the high commodities prices and clients' wishes for principal protection, we have received more requests on CPPIs linked to commodity indices,” he added.
To date, the energy commodity-linked product space has been far less exotic than other asset classes. “The work that has already been done in the equity and fixed income space means that [market participants] will not have to create a lot of systems from the ground up,” ABN AMRO’s Harburn said.
If commodity prices continue to grind upwards, more mix and match type commodity-linked hybrid products will start to emerge. "Trading of hybrid products is a specialist skill and energy is nowhere near as liquid as equity or fixed income. The skill in trading energy is how you source pools of liquidity - how you source liquidity in a volatile and illiquid market to replicate a required hedge," Harburn said.
Eventually, another risk that commodity-linked products will have to face relates to the behavioural differences in commodities themselves. "As the product set evolves and structurers create more funky types of products, the nuances of commodities will become more pronounced,” JPMorgan’s Owens said.
Certain clients feel more comfortable with exchange-traded funds (ETFs) than other commodity linked instruments, however. “[A commodity-linked ETF] would allow direct investment on an exchange in a basket of commodity risks, thus further opening up the space to new investors,” Rodgers said. A number of commodity ETFs on references such as gold and Brent already exist. There are also a few ETFs offered with commodity index underlyings, such as the Goldman Sachs Commodity Index (GSCI) ETF.
In the US, many new investors could be accessed via ETFs because structured notes have not had the same level of reception there as they have in Europe, Barclays Capital’s De Santos pointed out. In Europe, the ETFs might win new investors in the retail space, but probably not institutional clients, he added. Institutional clients typically invest in certificates because they are cheaper and tailor made. As there are not many certificate programmes in the US, the market for ETFs may be interesting even for institutional investors at this point, he noted.
Some market participants expect that the arrival of more commodity ETFs will be limited, as ETFs provide an alternative vehicle for delta 1/tracker products rather than structured volatility products.
“Clients have become focused on the behaviour of benchmarks such as the GSCI. To track a benchmark, a client must maintain a portfolio of futures positions, rolling this periodically. Recently, the impact of the roll process on total performance has been punitive," Owens said. The roll mechanism caused a net drag of about 16% on the performance of the GCSI over the last year because many commodity markets have gone into contango.
In instances when the roll is a drag on a commodity index, dealers are recommending that clients consider lengthening the roll, going into other indices, locking in a fixed roll cost or isolating a specific commodity and overlaying an index strategy with a strategy that provides for a reversal of the roll.
Commodity index products are clearly coming of age. Whereas clients were previously content being passively exposed to commodity indices, they are now looking to outperform commodity indices, one official noted.