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'Abandon hope, all ye who enter
...'
By Aileen Saw
HONG KONG
- During the 1997 Asian financial crisis and even
before, the US dollar had always been the safe-haven
currency du jour in Asia. Over the past few
years, Asian countries have taken that relationship to
the next level: US dollar-denominated structured
investments, a recently popular, risky and lucrative
financial animal.
To many in Asia, America remains
the land of the free market movements. And the larger,
more liquid Asian market for USD-denominated structures
means more hedge counter-parties, meaning more banks are
willing to quote USD-denominated structured investments.
This means competition is keener, margins leaner - all
good for the Asian investor.
As Ng Whye Keong,
interest rate structurer at Fortis Bank Hong Kong, put
it, "Huge demand for these kinds of structures in Asia
and attractive fees for banks willing to warehouse such
exotic risk result in many new entrants. As many banks
model and warehouse these structures, the demand and
supply means margins are lower. The once hugely popular
daily range accrual structure on LIBOR [London
Inter-Bank Offer Rate, the rate at which banks charge
each other on short-term money] is now trading like a
vanilla swap [a plain and simple instrument] - almost."
Keong was among the very few willing to speak on
the record about structured investments, mainly because
those who sell them, while ethically bound to explain
their high risks to potential clients, are not fond of
trumpeting their hazards to the world at large.
Indeed, Range Accrual and Callable Range Accrual
notes (as well as the Target Redemption Notes and the
Constant Maturity Swap Notes) are widely available at
almost every private retail bank. They can be found on
most bank websites, including those of DBS Bank, OCBC
Bank, United Overseas Bank (UOB), to name a few. Because
the notes have become so fashionable, banks are hiring
structuring experts to set them up.
We bid
farewell to the old faithfuls, Callable Range Accrual
structures among them, that have reassured us through
the era of the single-percentage-point USD benchmark
rate and, going forward, we say hello to the new-fangled
products that are just waiting in the wings to take the
investment world by storm.
During the past few
years of troubled times, with lean pickings in the
interest rate department, what was an investor to do?
Inflation in the US remained about 2-3% yearly, while
most Asian countries (with the exception of the Hong
Kong territory) fared little better. Until June 30,
however, the Federal Reserve Board (Fed) overnight
benchmark rate (the rate at which banks lend each other
US dollars overnight) hovered at a meager 1%. Which
meant your annual USD fixed-deposit was earning you in
the vicinity of 1-3%. Which then meant, after inflation,
your fixed deposit was effectively paying you next to
nothing.
Tiny quarter-point rate hike has
profound impact
Then the June 30 Federal Open
Market Committee (FOMC)meeting loomed and Wall Street
traders did much nervous hamster-wheel running for the
two weeks before that portentous date. Then, in the
deathly hush of an entire world market, holding its
breath, Fed chair Alan Greenspan announced a whole
quarter-point rate hike, leaving investors with all of a
benchmark rate of 1.25% to digest.
Not that much
to go on, you might say, not much food for thought; but
that teeny 25 basis point (bp) hike is the foremost
breeze heralding the winds of change for investment
products. Or the Four Horsemen of the Apocalypse, if you
buy The Inferno's warning about the dangers
ahead. Here's why.
In the era of the uni-point
benchmark rate, investors worked at beating the
devaluation of their assets due to inflation. But in the
wonderful world of structured investment products,
having to take on more risk in order to have more return
is as basic a law to investing as Newton's Law of
Gravity is to physics. With the US economy rife with
Enron-isms and consumer spending in a funk, investors
both in the US and in Asia were less keen on higher
yield (read: higher risk) investments. Thus began
another hey-day for the interest rate note family, with
all its close cousins.
In the land of the
interest rate note investors punt on where interest
rates will go, receiving an enhanced yield if they are
right (usually nothing if they are wrong - the most
popular interest rate notes are principal-protected). If
the Range Accrual Note was the dependable matriarch of
the family, then her daughter the Callable Range Accrual
Note must be the mother of all interest rate notes.
Investors clung to both, in times of need for more
yield.
Taking a step back to get to know these
structures better, interest rate range accrual notes
offer a coupon often substantially higher than a fixed
deposit. To partake of that coupon you needed to be
right about where a particular benchmark rate, typically
the six-month USD LIBOR was headed. You were paid a
portion of said substantially-higher-than-fixed-deposit
coupon based on how many days the six-month USD LIBOR
fixed within a predetermined range. On days when the
rate fell outside the range, no coupon would accrue to
you (hence the name range accrual - your coupon accrued
to you for every day the rate remained within the
range.)
In other words, if you were consistently
right about the six-month USD LIBOR and every single day
of the coupon period the rate fixed within the range,
you would get the entire
substantially-higher-than-fixed-deposit coupon. Since
you wanted the LIBOR rate to remain obediently in your
predetermined range, this product was perfect when you
thought rates were not heading north any time soon.
Add greater returns - and more
risk
Then someone had the bright idea of making
that substantially-higher-than-fixed-deposit coupon even
higher. How? By adding more risk to the existing
structure - by making the note callable. Thus the
Callable Range Accrual Note was born, where, for an even
higher potential return, the issuer, typically the bank
selling the note, could call the note back at leisure,
returning the investor's principal earlier than
expected. What was the additional risk? Reinvestment.
Still an acceptable risk to most, given the note would
be called back at par. But if your note is doing too
well (read: You made a good call, your note is going to
pay you all or most of that
substantially-higher-than-fixed-deposit coupon), the
issuer has the right to call the note and give you back
your money.
We can see why the range accrual
arrangement was a marriage of convenience between savvy
investor and not-too-risky product during the era of the
low interest rate. Since the product was often
principal-protected, the worst that could happen to an
investor was that he or she wouldn't get paid any return
if she or he were wrong about the benchmark rate. Not
exactly a very likely possibility with Greenspan and his
posse so famously eager to exorcise "an unwelcome fall
in the level of inflation" (read: deflation) a while
ago. Certainly all the more unlikely during the
cut-happy days of the Fed, when Feddies observed Central
Bank officials frantically sawing away at the benchmark
rate in an effort to jump-start the stalled US economy.
Add to that shot of sweet the fact the investor appeared
to be gambling an opportunity cost (the same money in
the investment could otherwise be placed in fixed
deposit) that was just a couple hundred basis points
above zero anyway.
One small step for the
Fed
With one little 25bp hike the Fed has taken
its first baby step along the long road to Hike City,
and herein lies that rude awakening, the end of that
honeymoon period for investor and product: Interest
rates are not going to remain low for the foreseeable
future.
Furthermore, since the investor is
gambling only his potential interest, with the low
interest rate levels, just how much can an investor
place on the table in order to purchase the derivatives
that will give him or her this wonderful
substantially-higher-than-fixed-deposit coupon? Therein
lies the rub: range accruals typically have to be fairly
long-dated (five years or longer) before you get an
attractive potential coupon.
If interest rates
do not remain low as punted on, the investor could be
stuck with an investment that pays low or no coupon for
the long life of the note. If the investor bought a
callable version, he or she would also be assured of
getting their money back early if they are not stuck
with a low-paying long-life note.
Hello,
next-to-nothing-paying fixed deposit scenario. Only,
investors don't often place five-year-or-longer fixed
deposits, do they? So, either abandon hope, all ye who
enter the inferno of the structured note - or hope
you're right.
Aileen Saw has worked on the structured product desks in
the Treasury & Capital Markets Departments of
Overseas Union Bank (OUB), now a part of United Overseas
Bank (UOB), and Hong Kong and Shanghai Banking
Corporation (HSBC) in Singapore.
(Copyright 2004 Asia Times Online
Ltd. All rights reserved. Please contact content@atimes.com for
information on our sales and syndication policies.)
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