Barclays Capital has launched a derivatives product – dubbed a collateralised commodity obligation – that gives fixed-income investors the opportunity to access
the commodities market. It is part of a recent trend to use innovative structures to eke out returns in an increasingly tight market. Saskia
After a massive 149 basis points of spread tightening on the Lehman Credit Index
since October 2002, portfolio managers are being forced to look for opportunities
outside their traditional asset classes. For those with a degree of flexibility
in their investment mandates, Barclays Capital recently launched the first structured
product to give fixed-income returns from a portfolio of commodities-based derivatives.
The new product, dubbed a collateralised commodity obligation (CCO), offers investors
high-yielding, rated paper for betting that commodity prices will not fall dramatically.
Matt Schwab, director in structured commodity products at Barclays Capital in
New York, says the new product is “the world’s first rated credit instrument
that provides fixed-income investors with access to commodities as an asset class”.
And in exchange for taking on commodities risk, investors earn a higher coupon
than they would for many other notes. For example, a five-year note rated double-B
plus might pay a floating coupon of about 4.5% over Libor. That spread is about
2.5% higher than the average for double-B rated US junk bonds, according to Banc
of America Securities’ high-yield index.
The new product joins a handful of other investments designed to give investors
access to commodities. One such product that has proved popular with investors
in Europe is the perfect asset allocation note (PAAN). These contracts are based
on several underlying references that are allocated a certain weighting. A basket
might comprise a commodity index, an equity index and a credit index; the highest
weighting is then given to the best-performing component.
Analysts explain that for fixed-income investors, holding exposure to commodities
is appealing on several levels. For one, after strong performance in 2003, commodities
were the best-performing asset class in 2004, outstripping the rather dismal
returns from the fixed-income and equities markets. While the Lehman US Aggregate
index returned under 5% in 2004 and the S&P 500 delivered just under 9%
for the year, returns on the Deutsche Bank Liquid Commodity Index came to 27.6%
and the Goldman Sachs Commodity Index returned 23%.
Michael Lewis, head of commodities research at Deutsche Bank in London, explains
that this performance has been the result of strong fundamentals in the commodities
markets – strong demand growth against a backdrop of constrained supply
– rather than a speculative bubble. “On the demand side,” says
Lewis, “there has been significant growth in commodities consumption related
to the industrialisation of China and India, as well as a spurt in consumption
from the United States.”
And on the supply side, Lewis explains that a deep slump in exploration spending,
combined with declines in the US dollar, has brought about a collapse in inventories
across all commodities markets. “The falling dollar has made commodities
cheaper in local currencies, so the normal supply response to greater demand
– more production – has been slow to take hold. This has resulted
in much more precarious inventory levels than four years ago,” says Lewis.
Prices have also been driven by a growth of negative supply shocks in the shape
of heightened geopolitical risk, war and some extreme weather conditions.
The outlook for future returns is also rosy. Stefan Weiser, head of European
commodity sales at Goldman Sachs in London, recently informed clients that:
“tactically, the outlook for commodities is secularly bullish, especially
given the capacity constraints caused by the significant underinvestment in
A further appeal of the commodities markets for fund managers facing paltry
returns from their fixed-income portfolios is that historically, commodities
markets tend to move independently of the fixed-income and equities markets.
Mohan Rajagopal, head of commodities correlation trading at Deutsche Bank, says:
“There is no strong perceived correlation between commodities and other
asset classes. In fact, historically, commodities have tended to be countercyclical
to the fixed-income and equities markets, with the commodities market producing
its best performance in times of poor performance in other markets.” The
result is that fixed-income investors are starting to see the commodities markets
as a useful, and high-yielding, tool for portfolio diversification.
Schwab at Barclays Capital says that the new product is designed to address
increased interest in the commodities markets by allowing fixed-income investors
to access the asset class through an investment structure that they understand.
“A lot of new clients expressing an interest in commodities either don’t
understand or don’t use total return swaps, which are the traditional means
of getting commodities exposure,” he says. “We spent a couple of months
scratching our heads over how to better structure these swaps, but, ultimately,
we decided that there had to be a different way to skin the cat.”
To provide investors with a concept of spread in the commodities markets, Schwab
and his colleagues gave the new product a similar structure to collateralised
debt obligation (CDO) products, which are created from a basket of underlying
bonds, loans or credit default swaps. The underlying securities in a CCO, however,
comprise around 100 derivatives known as commodities trigger swaps (CTS), based
on up to 16 precious metal, base metal and energy prices.
A commodities trigger swap, says Schwab, is best explained in comparison to
the more familiar credit default swap. “A credit default swap triggers
with some specified credit event, such as a default or debt restructuring. Similarly,
a CTS is triggered with a defined trigger event,” he says. But while a
credit event can trigger a credit default swap at any point during the life
of the contract, a CTS trigger event can only occur if the price of the referenced
commodity falls below an agreed level during a 10-day averaging period just
before maturity. Theoretically, the price of the referenced commodity could
remain below the agreed level for the life of the contract, provided the average
price for the last 10 days is above it.
Schwab adds that CTSs are also binary contracts, so if one is triggered, the
result is a complete loss of principal for the CTS buyer, equivalent to writing
a credit default swap with zero recovery.
Another difference, says Schwab, is that a CTS pays a structurally protected
coupon. “Because trigger events only occur in a short period before maturity,
investors receive all of their coupon flows before there is any observation
as to whether a default has occurred,” he says. This means that even if
there is a default at the point of maturity, the investor will have recovered
some percentage of the principal over the life of the transaction in the form
When combined into a portfolio for a collateralised commodity obligation, the
CTSs produce a structure that will have returns paid from a series of structurally
protected coupons until maturity (see chart).
Katrien van Acoleyen, an analyst in the structured products group at Standard
& Poor’s and instrumental in developing the agency’s ratings approach
for CCOs, explains: “Conceptually, a CCO structure is very similar to that
of a single-tranche CDO, the only difference is the need to assess a new underlying
credit risk, which requires a data set of historical prices rather than a data
set of corporate defaults.” Fortunately, there is a wealth of historical
data on the commodities markets, but in the interests of conservatism and to
avoid the smoothing effect of time on the large data samples, S&P based
its ratings on the most volatile period.
Thus far, Barclays Capital has issued $300 million of CCO paper, and is hopeful
of placing a further $500 million. Schwab says that early adopters of the product
include credit hedge funds, banks’ proprietary desks and other investors
with a degree of institutional flexibility. “But we’re seeing interest
from a broad spectrum of institutional investors, including public pension systems
and insurance companies. It will just take some time for the more regulated
entities to go through the necessary hurdles before they can invest in a new
product,” he says.
In the meantime, Schwab has high hopes for the product in 2005.
“We’re working to issue CCOs backed by different assets, with different
maturities and in different currencies. We’re expecting at least one other
investment bank to launch a version within the next six months and we’re
looking forward to the competition.”