Yuletide investments, ho ho ho

Buttonwood

Dec 13th 2005 FRANKFURT
From The Economist Global Agenda

Structured bonds for retail investors, all the rage in Germany, can often turn out to be Santa’s little joke at their expense

AT THE Weihnachtsmarkt, Frankfurt’s bustling Christmas fair, as the whiff of pine, gingerbread and Glühwein assaults the senses, one’s thoughts turn naturally to those less fortunate than ourselves: the handful of financial institutions which cash in on the spirit of Christmas to borrow money. There is the Nikolausanleihe, issued by Deutsche Bank (Nikolaus is the German for Father Christmas), the Christkindl (Christ child) bond issued by Credit Suisse First Boston, and the Wintertraum (winter dream) bond proffered by J.P. Morgan.

Actually, as these banks will hasten to tell you, one man’s debt is another man’s investment opportunity. And these Yuletide offerings are debt securities that bring the chance of a fantastic gain for investors, if only certain market conditions are met. Take the Nikolausanleihe II, successor of last season’s successful Mark I. In the first two years of this seven-year bond a coupon of 5% is paid. From years three to seven this is topped up by 20% of the return on the poorest performing of a basket of 25 international shares. That is the upside. The downside is that if that return is negative, the year’s coupon is reduced, to a minimum of 1%. At worst the investor earns 15% over seven years.

Now in most countries, investors wouldn’t touch such a gamble with a barge pole. Given the poor record of corporate foul-ups these days the chances of one company in 25 getting it badly wrong at some time in the next seven years are pretty high.

But German Muttis and Papis love this kind of stuff, despite their aversion to risk of any other kind (except perhaps when they sit at the wheel of a BMW). They appear ready to bet royally on the chance of a heady return linked to a stock index, a basket of shares, currencies, commodities, or even private equity and hedge funds. These structured bonds, covered warrants or Zertifikate (certificates) have been around in one form or another since the early 1990s. The number has grown each year, to around 70,000 today. The total value of outstanding securities is estimated to be €75 billion.

The list of issuers is headed by some less usual suspects: Commerzbank, Sal Oppenheim, and HSBC Trinkaus & Burkhardt. But sheer volume isn’t everything. The certificate business is surrounded by a huge amount of hype. Every November it has its own version of the Oscars, at which issuing houses are praised for their proficiency in the various categories: index products (Deutsche Bank), discount certificates (Sal Oppenheim), knockout certificates (ABN Amro), or innovation of the year (UBS). Deutsche won the overall prize for best issuer, but DZ Bank won the people’s vote for the third year running as “certificate house of the year”.

For the banks, certificates have been money for old rope. They are basically option products, and banks, by and large, are better at pricing options than their customers, especially retail investors. The certificates tend to be bought for their novelty value, or because they chime with an investor’s view, rather than on the basis of hard-nosed probabilities. And generally the true cost, in terms of what the customer is paying for his option, has been far from transparent. For example, some equity-index products do not include dividend payments; these are used instead to “pay” for the option premium. Issuers often charge fat fees for investments in static baskets, in which no active management is involved. Front-end costs to get in on the deal can be as high as 4%. And for those who want to get out again the bid/offer spread can be 6%. What is often forgotten too is that these instruments are a loan to the bank in question, yet the investor is offered no credit premium for the risk, however small, that the bank might default.

The Stuttgart stock exchange, which specialises in these certificates, and EUWAX, its main broker, have brought sharper pricing, especially to standard equity-index products. But for more complex items the only marketmaker is the issuer itself. Extraordinarily, Dresdner Kleinwort Wasserstein will make you a daily price for its P3 Private Equity Performance Certificate; but don’t expect it to use its slide rule in your favour.

This market niche is like many others: as one product gets commoditised the issuers hurriedly design something more exotic, on which the margins are higher and the workings less transparent. On the other hand, because of public indignation banks are beginning to pay more attention to what is in the interests of the customer. In 2003 the Frankfurt bourse started its own certificate segment, Smart Trading, to compete with Stuttgart. Deutsche Bank, which supported Frankfurt against Stuttgart, has settled its differences with the rival exchange and began listing its certificates in both places at the beginning of this month.

Recently, however, DZ Bank has stolen the limelight as the customer’s friend, by getting its certificate-design procedure approved by the TÜV. Most Germans think of the TÜV as the institution that supplies the annual roadworthiness certificate for their motor cars. Well, the TÜV’s southern office, in Munich, does technical checks on many other things, including banks. It has inspected DZ Bank’s process for designing certificate products from the point of view of customer protection and finds it excellent.

That doesn’t mean, the TÜV hastens to add, that it studies the risks and rewards of each product. The customer has to do that himself, and sign at the bottom to confirm that he understands exactly what he’s letting himself in for. For example, it is he who must decide whether DZ Bank’s Pluszins Garant Rebound 3 is a better bet than Deutsche Bank’s Nikolausanleihe II. DZ’s basket has 20 rather than 25 shares; but whereas Deutsche’s kicks out an offending share at the end of the year, DZ Bank’s does not. You pays your money and you takes your choice. Or rather, if you’re sensible, you invest in something safe and put the money you’re prepared to lose on a horse.

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