Barclays' $27.72 million notes linked to commodity strategy indexes bid by alpha seekers

By Emma Trincal

New York, Dec. 12 - Barclays Bank plc's $27.72 million of 0% notes due Jan. 10, 2013 linked to the Barclays Capital Commodity Based Alpha Trading Strategy VOLT 5% Total Return index and the Barclays Capital Commodity Strategy 1599 Total Return index were bid by sophisticated investors eager to generate alpha in the commodity space, Philippe Comer, head of commodity investor structuring in the Americas for Barclays Capital, told Prospect News.

"We had a lot of demand from institutional investors and high-net-worth clients who need to address the contango or backwardation issues for their commodity exposure," he said.

Commodity indexes are composed of futures contracts that are rolled on a regular basis because there is no physical delivery.

Contango is a source of return erosion in an index. It occurs when the expiring contract that gets sold has a lower price than the nearby contract to be purchased for replacement. The contango curve creates a negative roll yield. The opposite situation, characterized by a positive roll yield, is called backwardation.

"The notes are tied to two proprietary indexes that seek alpha in the commodity space. They allow investors to take advantage of the curve dynamic - which is accomplished with ComBATS and to find a better timing to roll the underlying futures contracts, which is the purpose of the timing arbitrage index," said Comer.

Curve, congestion

The Alpha Trading Strategy VOLT index, or ComBATS index, seeks to capture returns from the potential relative outperformance of notional-weighted long positions in certain momentum alpha indexes compared with equivalent notional-weighted short positions in corresponding single-commodity nearby indexes, according to a 424B2 filing with the Securities and Exchange Commission. It targets a volatility level of 5% by employing a non-discretionary process to dynamically adjust its exposure to the index components.

The Barclays Capital Commodity Strategy 1599 index, referred to as the timing arbitrage index, looks to capture returns from the potential relative outperformance of weighted long positions in certain modified single-commodity indexes compared with equivalent notional weighted short positions in corresponding single-commodity indexes.

The "modified" contracts simply roll their position two weeks prior to the single-commodity contracts.

The pre-rolling ahead of the benchmark allows exposure to a less crowded part of the curve, one with less "congestion," explained Comer.

The payout at maturity will be par plus the basket return, which could be positive or negative. The indexes are equally weighted in the basket.

The final level of the basket will be reduced by a custodian fee of 0.1%, and the return of each index used to calculate the final basket level is reduced by a fee, which is 1.25% per year for the ComBATS index and 1.6% per year for the 1599 index, according to the prospectus.

Return-driven

Comer said that sophisticated investors who seek commodity exposure have very specific goals in mind when investing in those types of notes.

"The return characteristics is what is driving demand for the transaction," Comer said.

"Both strategies associated with the underlying basket are absolute return oriented, which is what made the offering successful. People want enhanced returns in the commodity asset class as well as controlled volatility."

The back-tested performance of the ComBATS index over the past 10 years is 10.29% per annum with a volatility of 3.83%, said Comer.

The timing arbitrage index with a four-times leverage factor generated 14.67% per annum with a 6.51% volatility.

The ComBATS index was created in January 2009. There have been $1 billion of notes linked to this index in both the registered and private space.

The issuance amount of private and registered notes linked to the timing arbitrage index is $500 million. The index was launched in October 2010.

Low correlation

Another advantage of including the two indexes in the same basket is that they show very little correlation, said Comer.

"It's because ComBATS, associated with curve behavior, works on the longer end of the rolling curve while the timing arbitrage strategy, addressing the issue of congestion, is very short term. The concepts are very distinct and the sources of returns very separate. Yet, you can access the two different sources of alpha in one go," he said.

Retail

The size of the deal surprised a financial adviser who caters to the retail market.

He said that notes linked to complex, proprietary indexes do not typically sell in large offerings, at least not in the retail market, as investors and financial advisers alike have a hard time understanding or explaining what he referred to as "black boxes."

"If they sold $28 million of it, I guess it's a good size, but they also have a big sales operation," he said.

"I don't follow these types of products, but it seems like the typical user would be a commodity investor, someone who already owns the stuff and needs a hedge.

"To me, it looks more like a gamble since you don't have any downside protection.

"The fees are not heavy, and it's a good thing that it's putable. But I'm not sure I like the fact that the notes can be called anytime," he said.

The notes are putable at any time, subject to a minimum of 250 notes, and they are callable at any time at the discretion of the issuer, according to the prospectus.

"If they can call it anytime, they could just do it when it's not in the investor's best interest," he said.

But Comer said that the call feature had "no economic impact" because the structure was a simple tracker.

"These notes trade and settle against the value of the index. It's a delta one type of structure," Comer said.

"Whether the notes trade under par or above par, if an early call takes place, the investor receives the full value of the note as if it was redeemed on the exchange."

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