By Theo Casey, a columnist at Futures & Options World, blogging on the back of FOW’s European Equity Options conference in Amsterdam.

The 2008/09 global interest rate dunk hit structured products hard.

Particularly hard hit was the capital guarantee wrapper.

When the five-year swap rate fell to 2 per cent, five-year zero-coupon bonds “de-discounted” to around 85 on the dollar*.

*This is an aggregation. Specific discount levels depend on where you shop – different banks’ bonds have different credit spreads that reflect their respective credit ratings. The bigger the discount, the more one can spend on the option. BUT, if the discount is really big, one ought to make enquiries as to the level of credit risk they are implicitly being asked to take. It’s probably a lot.

[COUGH] Post Office inflation products provided by Bank of Ireland are a case-in-point [COUGH].

Why is this important?
Because bonds are the core filling in a structured product pie. They represent around four-fifths of the cover price. The other fifth goes on an equity option and fees.

A product that, pre-rate cut, guaranteed one’s investment over five years now cannot. The investor’s money would be tied up for upwards of six years while the discount ticks up to par.

And, so I’m told, even structured product investors don’t wait that long.

However, if you take a step outside of the equity market, you find some fascinating quirks that allow more bang for one’s buck.

This is particularly apparent in agricultural commodities. It’s thanks to what is known as the “convenience yield”. Allow full-time structurer Jakob Bronebakk from Jubilee Financial Products to explain:

The forward curves for equity indices are almost exclusively driven by the difference between interest rates and dividends. The commodity curves, on the other hand, can show large contango or backwardation based on the fact that for some things, such as food or energy, having it “in the hand” can be much more valuable than having it “in the bush” – i.e. in the future.

This is good old backwardation – with some things, you’ll pay more to have it now.

Take corn, a strongly backwardated commodity, as an example. The current price for May 2011 Delivery is $768 a bushel (at pixel time). Delivery for May 2012 delivery is just $669 a bushel. The further out you go, the cheaper the forward. And low forwards make for cheap option premiums.

And cheap option premiums give the structurer a few more bob to spend on those pricey bonds. Thus, you don’t have to wait another year or two to get the capital guarantee.

This is good news for those that build products and those that want to buy them. The cruel irony is that this opportunity afforded by the term structure is probably a bit technical for the target audience to appreciate. “Contango, backwardation and the pleasing implications for product design” is not a conversation investors can expect to have with their financial advisors any time soon.

While the cheapness of the option does compensate for the crummy discount on the bond, the punters will probably never know. Pity.

 

This entry was posted by Guest writer on Monday, April 11th, 2011 at 18:44 and is filed under Capital markets, Commodities. Tagged with backwardation, commodities, contango, structured products. Edit this entry.