Deutsche Bank’s leveraged notes linked to Bloomberg Commodity offer commodity alternative

By Emma Trincal

New York, Dec. 14 – Deutsche Bank AG, London Branch’s 0% enhanced participation securities due Dec. 23, 2020 linked to the Bloomberg Commodity index give investors a good reason to buy the notes as the risk-reward profile appears more attractive than a fund tracking the index, advisers said.

The question is whether investing in a broadly diversified commodity benchmark in the current sell-off makes sense even long term.

If the index return is positive, the payout at maturity will be par plus 150% to 170% of the index return, according to an FWP filing with the Securities and Exchange Commission. The exact participation rate will be set at pricing. If the index return is negative, investors will be fully exposed to the decline.

Terms

Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments LLC, said that he likes the structure.

“One-to-one on the downside and one point five-to-one on the upside favors the investor,” he said.

“It’s a five year: you’re giving up some liquidity, but the fact is you don’t have a cap, which is very significantly positive.”

Kaplan said his “only concern” is the underlying itself.

The Bloomberg Commodity index, formerly known as the DJ-UBS Commodity index, is composed of futures contracts on 22 physical commodities and is designed to be a benchmark for commodities as an asset class, according to the prospectus.

Administered and rebranded by Bloomberg since 2014, the Bloomberg Commodity index allocates about a third to energy futures, less than a third to metals, about 30% to agriculture and nearly 5% to livestock as of Oct. 31, according to a Bloomberg fact sheet.

Rolling

“Since it’s an index of futures contracts, you’re exposed to rolling. It gives you exposure to contango, which eats up your return,” Kaplan said.

Future contracts in the index are not physically delivered but rolled to a later date, explained the prospectus in the selected purchase considerations section.

When a contract nears expiration, it has to be sold and replaced by the purchase of another one further on the futures curve.

When the prices of distant delivery months are higher than the nearby contracts, the market is known to be in contango. In such scenario, contango creates a loss in connection with rolling since the cost of buying a contract at a later expiration date exceeds the proceeds received from selling at the spot price.

The opposite type of market is called backwardation. It benefits investors for the opposite reason. Investors in backwardation gain from the positive roll yield.

“Contango is an enduring problem with commodity futures. Sometimes it’s even a good idea to be short,” said Kaplan.

“You get contango most of the times with commodities. It’s certainly true with oil where backwardation is rare, and it’s also true with metals. Occasionally you could get backwardation in agriculture, but it’s not that often.”

Alternatives

“That’s why I would rather invest in some ETFs that hold the physical commodity itself,” he added, citing the SPDR Gold Trust exchange-traded fund.

“I would also prefer to buy the stocks of companies that produce commodities. You can use the Energy Select Sector ETF. That’s energy only, but there are some equity ETFs that offer exposure to the stocks of companies producing commodities in a broader way.”

He pointed to the Market Vectors Natural Resources ETF, which is based on the Rogers-Van Eck Natural Resources index developed by commodity investor Jim Rogers.

“That way you don’t have to worry about the cost of rolling the futures contracts.”

However, investors who do not see contango as a significant risk could consider the notes as a good option, he said.

Unnecessary risk

“A lot depends on what you’re trying to achieve. I personally don’t want something that has the potential to erode the value of my investment,” he said.

“I use the same logic when I stay away from high-fee types of instruments.

“Same thing with a structured note that would cap my upside and not my downside: a poor risk-reward profile is a red flag too.

“My problem with this note is not the risk-reward, which is good for the investor. It’s the index itself. I just don’t want to be exposed to futures.”

Leverage

Kirk Chisholm, wealth manager and principal of Innovative Advisory Group, also likes the terms but is more skeptical about how the macroeconomic environment may support a bullish bet on commodities.

“I don’t see any issue with this kind of note assuming you’re going to invest in the Bloomberg Commodity index,” said Chisholm.

“I have no issue with 1.5 times the upside and no cap with a downside that’s the same as the index.

“For an all-commodity diversified exposure, that note is the way to go. You get a better return, and the risk is the same.”

However, the direction of commodity prices in five years is hard to predict and the outlook now is very negative, he said.

“Whether it makes sense to invest in this index is another story.”

Deflation

“Obviously we have a commodity deflation in the world. I don’t see any reason why it would stop in the near future,” he said.

“Crude is at its 2009 lows, so it might be a good entry level. For people who have that view, the notes may present a good opportunity.

“But as the deflationary cycle continues it’s hard to see how we would come out of it.”

Index exposure

“The question of contango is not really the issue, in my opinion,” he said.

“Contango and backwardation are always temporary. Depending on the timeframe you could have either one of those. You’re taking a five-year bet. It’s really irrelevant whether we have contango or backwardation right now. It’s going to change anyway.

“This note is just for people who want access to this index. You get energy, grains, industrial metals, precious metals. It hits most of the buttons people want to hit.

“If you want to get exposure to the Bloomberg Commodity index –and that’s what the note is designed to do – there aren’t that many ways to do it.

“An ETN or ETF isn’t going to give you leverage on the upside and one-to-one on the downside, so I think it’s a reasonable note. It’s a better alternative to any possible fund that may just track the index.”

Substitute

But the commodity outlook is blurry, making Chisholm uneasy about the underlying investment theme.

“The only issue I have is macro,” he said.

“Commodities don’t do well in a deflationary environment, which is what we have.

“The dollar is appreciating. As long as it continues to appreciate, commodities won’t do all that well.

“That said, five years is a long time. The dollar may depreciate a little bit, and you could get a reasonable increase in commodities prices. Five years from now, prices could easily be higher than what they are now.

“So for people who want to have an allocation to the asset class, this note is a good substitute for commodities in the portfolio.”

Deutsche Bank Securities Inc. is the agent.

The notes are expected to price Friday.

The Cusip number is 25152RV34.

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