The return of cheap commodity funding | FT Alphaville

The return of cheap commodity funding

Deutsche Bank on Tuesday revealed it was issuing “three-year market contribution securities” linked to the Deutsche Bank Liquid Commodity Index – Mean Reversion Plus.

The SEC filing, brought to our attention by Thomson-Reuters columnist John Kemp, summed up the securities as follows:

• The securities are designed for investors who seek a return linked to the performance of the Deutsche Bank Liquid Commodity Index – Mean Reversion Plus™ Total Return (the “Index”). Investors should be willing to forgo any coupon payments and, if the Index does not appreciate by approximately 4.06% or more over the term of the securities, be willing to lose some or all of their initial investment.
• Senior unsecured obligations of Deutsche Bank AG due January 17*, 2013.
• Minimum denominations of $1,000 (the “Face Amount”) and integral multiples of $1,000 in excess thereof.
• The securities are expected to price on or about January 12*, 2010 and are expected to settle three business days later on or about January 15*, 2010.
• After the Trade Date but prior to the Settlement Date we may accept additional orders for the securities and increase the aggregate Face Amount.

Delving a little deeper, the filing also showed that:

Your investment will be fully exposed to any decline in the Index. If the Final Level on the Final Valuation Date or the Early Redemption Valuation Date, as applicable, is less than the Initial Level, you will lose 1% of the Face Amount of your securities for every 1% that the Final Level is less than the Initial Level. In addition, the Adjustment Factor will lower your return, regardless of whether the Index appreciates or declines in value. In no event will the Redemption Amount be less than zero.

Index-linked securities are, of course, nothing new — even non-principal protected ones.

What’s more, the note above refers to a Deutsche Bank series registered back in September 2009.

Nevertheless, an interesting point is made by John Kemp on the matter. As he wrote on Tuesday:

In effect, investors get exposure to changes in the value of the commodity index but structured in the form of a loan to Deutsche Bank with a single payment due in three years’ time. The bank receives cheap funding — but gets a short exposure to the commodity market. The loan can be used to create a short position or offset existing long positions elsewhere in the bank’s book, otherwise it will need to be hedged out.

Creating an internal short position in this manner is presumably useful for any institution that has long exposure to commodities but is constrained by position and accountability limits.

And as Kemp notes, the securities are also a useful way to access cheap funding.

With that in mind it’s interesting to observe that issuance of such notes is again beginning to pick up again after slowing in 2008 and 2009.

Undoubtedly, this is connected to a return in bullish commodity sentiment and  consequent uptick in demand for such products.

It does, however, provide a useful and cheap funding window to those capable of catering to the demand in the near term.

Indeed, according to Barclays Capital’s Commodity Investor research note, a trough in issuance may have been reached in November 2009.

As the analysts noted in December:

While sentiment towards commodity investments has turned more constructive, structured products are yet to be big beneficiaries of the pick-up in flows from institutional or retail investors, as is evident from y/y declines in the notional value of new issuance (Figure 13).

The trough for issuance was reached in November, when it fell more than $1.7bn y/y, and though the absolute value of issuance is now improving again, the year-to-date decline stands at a hefty $6.5bn, with relatively expensive options, high volatility and contango curves all playing a part.

However, more recently there has been a pick up in notes on relative value and long-term absolute value trades because these are giving investors the flexibility to gain from sideways movements in the short term and bullish trends in the medium term. In fact, November was the first month this year in which issuance recorded a y/y increase, of $70mn, but this was largely due to the low base effects of last year. Since Q3, issuance has stabilised at about $570mn per month, on average.

Inflows into such commodity securities might consequently be worth watching, alongside those into traditional funds and exchange-traded products this year.

Related links:
Commodity index inflows are back
– FT Alphaville