Svensk's $59.5 million notes tied to Dow Jones-UBS Commodity seen as rate bet, risky structure

By Emma Trincal

New York, April 13 - A floating-rate note tied to a rolling commodity index was seen as a timely play against inflation by some while others said that the structure was too complex and too risky to benefit investors.

AB Svensk Exportkredit priced $59.5 million of floating-rate notes due May 15, 2012 linked to the Dow Jones - UBS Commodity Index Total Return 2 Month Forward via Merrill Lynch, Pierce, Fenner & Smith Inc., according to an FWP filing with the Securities and Exchange Commission.

The offering was the top deal priced last week.

Interest equals Libor minus 50 basis points, subject to a floor of zero. It is reset quarterly and payable at maturity.

The payout at maturity, in addition to interest, will be par plus triple the sum of the index return minus the T-Bill yield minus a fee of 0.35% per year. The T-Bill yield will be the sum of the 91-day weekly auction high rates for U.S. Treasury bills for each day during the life of the notes.

The notes are putable at any time if requested by all holders, and the notes will be called if the index closes at 15% or more below its initial level. In each case, the payout will be calculated in the same way as that at maturity.

The notes are designed "only for sophisticated investors" who are "experienced" in derivatives, the prospectus said, given the notes' "speculative" nature and the degree of risk they involve.

The Dow Jones - UBS Commodity Index Total Return 2 Month Forward is a rolling index designed to track the index composition two months into the future.

Rate hike bet

"This is a play on an interest rates hike, and it's probably being sold as a hedge against inflation," said a New York sellsider.

He noted that some investors are beginning to bet on higher interest rates based on several recent changes.

"The European Central Bank raised its rates recently; most major countries have enjoyed an economic recovery for some time; QE2 is ending in June. All those signs seem to imply that a change in monetary policy in the U.S. is imminent," he said.

Because the coupon increases with Libor, investors who bought the notes are betting that the Fed will soon shift to a less accommodative policy.

"It's not a bad deal, and the timing is right. You always have to price those deals ahead of the Fed. Even a few weeks before, it's already priced," he said.

Floaters appeal

This sellsider said that one element behind the popularity of the offering was the floating rate structure.

"With a floating rate like this one, you get some protection against interest rate risk because the floater limits the potential depreciation of your bond if interest rates go up," he said.

"When you have a portfolio crowded with zeros, floating rates reduce risk and can be helpful.

"I would imagine that it's one of the reasons behind the success of the deal.

"Floaters in general have become very popular."

Beside the point

But Eric Greschner, portfolio manager at Regatta Research & Money Management, said, "Honestly, I don't understand why this deal was so popular."

He first criticized the language of the prospectus itself.

"I'm puzzled by the complexity of this deal. The prospectus is poorly written. Even if I liked it, I would be reticent to invest in this deal because of its complexity," he said.

Secondly, Greschner did not find the coupon structure all that attractive given how low rates are today and how short the tenor of the notes is.

"I don't see the point of the floater when you consider the potential risk of loss," he said.

"This is an enhanced growth product with a small floater component.

"Libor is 28 basis points; you're not even getting a coupon right now. How much will interest rates have to rise in 13 months for you to earn anything?

"And who cares [about] earning such marginal interest when you can lose 45% of your principal or more?"

Symmetrical leverage

Greschner said that the prospectus was also not clear in describing the downside risk, an important aspect of the structure since the three-times leverage factor applies not only to the upside but also to the downside.

While the notes get called if the index closes at 15% or more below its initial level, Greschner said that it could be more assuming a large decline in one day. Even if the call is triggered just on the 15% decline, the loss of principal would be 45%, or three times the trigger, he said.

"I simply don't like the leverage on the downside," he said.

"It's a concern from a risk-management standpoint.

"One of the most attractive features of structured products is that they give you asymmetrical leverage.

"Here, leverage is symmetrical. It makes the structure weak."

Risky asset class

Greschner said that the underlying itself significantly adds to the risk.

"Commodities are very volatile. Many predict a sell-off," he said.

Among those, he cited Goldman Sachs, which came up with a negative report on oil and commodities on Tuesday.

"There are a few reasons to be concerned with commodities: the end of Q2; the fact that the dollar has closed its long-term support level; and the Goldman report, which has been a catalyst for a lot of the pullback this week," he said.

The call feature brings some sort of "risk mitigation," he said. But the protection would have been better achieved through a barrier, he added, in particular a "European type of barrier that would give you 13 months to make up for losses, rather than an American barrier where you can be quickly out."

Investors seeking commodities exposure could find better alternatives, he said.

"You can construct a safer product leveraging an ETF and hedging it with options," he said.

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