BNP Oscillator Commodities index debuts as underlying for registered note; RBC to issue deal

By Emma Trincal

New York, March 30 - Royal Bank of Canada plans to issue a note based on a commodity index not used in a registered note before but known among investors in the private placement market, according to a market participant and information compiled by Prospect News.

RBC will price 0% commodity-linked notes due April 20, 2016 tied to the BNP Paribas Oscillator Commodities Target Volatility 8 USD Excess Return index, according to an FWP filing with the Securities and Exchange Commission.

The index consists of up to 19 commodity indexes, each based on rolling individual commodity futures contracts and not on the spot prices of the underlying commodities. The 19 portfolio components are diversified across four different asset classes: energy, base metals, precious metals and agriculture.

The payout at maturity will be par plus 70% to 80% of the index return, subject to a minimum payout of par.

Private no more

"BNP has done a lot of private placements with this index. It may be the first use with an external issuer," the market participant said.

The deal would be the first one in the United States to be registered with the SEC, according to information compiled by Prospect News.

This market participant said that about $1 billion has already been invested globally in the BNP Paribas Oscillator Commodities strategy since the index was created in October 2007.

"The strategy has been used either through swaps with hedge funds and asset managers. You also have options on it or private placement notes linked to it, or it's done out of certificate programs. Harewood Asset Management runs a $700 million fund using this strategy in Europe," he said.

RBC and BNP Paribas have developed a "good partnership," facilitating the choice of RBC as the issuer, he added.

"The partnership makes sense between the two entities. You have two AA-rated banks; two strong counterparties. It's a good credit package.

"Also keep in mind that the big U.S. investment banks already have their own commodity indexes."

Several commodity indexes offer some of the features available with Oscillator, the market participant noted.

But he added that the BNP strategy is "different" because it combines four different attributes into one strategy.

"The Oscillator Commodities strategy offers four things: a wide investment universe of 19 different commodities, the ability to rebalance the allocation daily, a dynamic roll and some volatility control through an 8% volatility target," he said.

Dynamic allocation

The Dow Jones - UBS Commodity index represents 19 commodities, which are weighted to account for economic significance and market liquidity.

But there is more diversification in the S&P GSCI, which references 24 futures contracts, according to Standard & Poor's.

What makes the BNP index stand out, this source said, is the "dynamic allocation across the 19 commodities versus a static allocation seen with most commodity benchmarks."

The Oscillator Commodities index is designed to react dynamically to changing market conditions, while the Dow Jones - UBS Commodity index and the S&P GSCI index allocate the commodities via a "static weighing system," he said.

"The weightings are not set in stone with the BNP index. There is a dynamic adjustment based on market movements and volatility. The index is overweight commodities that are on a bullish trend and underweight commodities on a bearish trend. It can significantly outperform static allocation indexes."

This feature may be particularly appealing to investors who seek to gain access to commodities but are not sure where to allocate across the various individual commodities.

"People want access to the commodity space. Problem is that investing in commodities is not as easy as investing in equities," the market participant said.

"When the market is up in equities, most stocks tend to go up and so you can easily follow a benchmark and buy the S&P 500. But in the commodity space, there is a strong decorrelation between asset classes. Energy prices could be falling while the price of gold would be climbing.

"This is why there is demand for this type of strategy. It gives investors the ability to maximize returns based on the performance of the respective commodities."

Optimizing the curve

The rolling optimization feature is used in several competitive indexes, but BNP Paribas has been a pioneer in this field, according to this source.

"BNP was one of the first to apply the idea of optimizing the shape of the futures curve by rolling through different maturities. The recent S&P GSCI Enhanced index is a continuation of this approach," he said.

As the futures contracts included in any commodity index reach their expiration date, they are rolled into new contracts. The sale of the expiring contract is used to purchase longer-dated futures contracts. A market is said to be in contango when the price of longer-dated contracts is higher than near-dated contracts and spot prices because the cost of replacing the contracts has become more expensive.

"For each individual commodity, the index can optimize the cost by looking at the shape of the curve and rolling wherever it's the cheapest," the market participant said.

"If the curve is in contango, the index is going to be rolling at the end of the curve, where it's cheaper than in the front."

Volatility target

Finally, the Oscillator index strategy aims to achieve a target volatility level of 8%.

"If volatility is at 4%, the index can have a 200% allocation to the basket and hit the 8% target. If on the other hand, volatility is at 16%, you only get to be 50% allocated," the market participant said.

"Since the basket constituents are futures contracts, a change in allocation simply means adjusting the number of contracts accordingly.

"This gives the investor a way to ride a bull market and to be protected in a bear market."

The notes (Cusip: 78008K3K7) will price April 15 and settle April 20.

RBC Capital Markets, LLC is the agent.

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