Deutsche Bank's 10-times leveraged renminbi-linked notes highly risky, unusual, observers say

By Kenneth Lim

Boston, Feb. 17 - A highly leveraged structured product linked to the exchange rate between the Chinese renminbi and the dollar is a very risky investment that is probably suitable for only a minority of investors, observers said.

Deutsche Bank AG, London Branch priced $930,000 of zero-coupon enhanced participation notes due Feb. 24, 2012 linked to the performance of the renminbi relative to the dollar.

At maturity, investors will receive par plus 10 times any gain in the official dollar/renminbi fixing rate. The spot rate increases if the renminbi appreciates against the dollar. But because the notes were sold at 103.75% of par, investors make a profit only if the spot rate gains by more than 0.375%.

If the spot rate falls, investors will lose an amount equal to 10 times the decline, up to the full amount of the principal. Investors will therefore lose their principal with just a 10% decrease in the underlying rate.

The starting spot rate is 6.425.

Unusually high leverage

The participation rate of 10 times on both sides of breakeven was unusually high. That, combined with the lack of a cap on gains and losses made the product rare.

"Oh, wow," was the first response by investment adviser Clemens Kownatzki of FX Investment Strategies LLC, an independent alternative investment advisory firm that specializes in global financial markets.

"I personally wouldn't recommend it even to my high net worth clients," said the former currency trader.

Noting that investors are in effect paying a 3.75% fee as well as getting themselves locked in for one year, Kownatzki reckoned that there was probably a less risky way to achieve a comparable result.

"If it's a currency leveraged trade, in the FX market there's a gazillion brokers that can offer me options," he said. "With something like this, I still have [exchange-traded fund] options, and rather than be tied into a one-year contract, I'd rather find some other way to leverage, like shorting T-bills or some other way. I can get out of an ETF in a second, and I would feel more comfortable with that."

Kownatzki said currency-linked structured products are usually more attractive when the underlying is a basket of currencies as opposed to just one currency pair.

"That's because that's more difficult for investors to manage on their own," he said.

Long on renminbi

The notes are clearly for investors who are bullish on the strength of the Chinese currency, given the lack of downside protection and the highly geared upside, but the truth is that most of the market is long on the renminbi, Kownatzki said.

"It appears to everyone that that's the only way to go, for the renminbi to appreciate," he said.

Nevertheless, the Chinese government has been "very adept" at taking the speculative element out of the market, Kownatzki added. And if everyone is making a levered bet on a stronger renminbi, there must be someone taking the opposite position.

"I always question what's the other side of the trade," he said.

And investors cannot ignore the possibility that the yuan may still weaken versus the greenback. After strengthening consistently over the past few years, the renminbi could be vulnerable to a technical correction, Kownatzki said. Fundamentally, there is also concern about the health of the Chinese economy and inflation.

"There's growing concern than China may have maybe more than a soft landing, like a semi-hard landing," Kownatzki said. "There's a huge property bubble, inflation, and now they're talking about increasing reserve ratios to 21%. ... People expect the renminbi will appreciate, but I think there's a potential that they might pull back some if they're more concerned internally, domestically."

Confident investors

The notes may nevertheless be attractive to sophisticated investors who have a high risk tolerance, one distributor said.

"There are products like these where the lack of downside protection would scare away most investors, but they're not really targeting most investors," the distributor said. "Obviously there's a lot of risk involved, but there are some investors who have done a lot of research and who feel very confident about taking certain positions, and the lack of a downside does not bother them as much. And of course the flip side is you've got an incredibly high leverage on the upside as well."

The distributor added that investors may have other ways to hedge the downside of the product.

"Sometimes you can't look at one product on its own," the distributor said. "You've got to look at where it goes in the portfolio, and then maybe it makes better sense."

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