SPA Conference: S&P Dow Jones Indices predict that commodities notes are due for a comeback

By Emma Trincal

New York, March 11 - As a commodity rally is underway this year while the direction of equity markets is anyone's guess, some predict that 2014 will see the return of commodities as an underlying asset class of choice for structured notes.

Jodie Gunzberg, global head of commodities at S&P Dow Jones Indices, during a presentation at the SPA 2014 Annual Structured Investments Distribution Conference held in New York on Monday, said that "the cycle may be switching" to favor commodities over equities.

During her presentation - called "Commodities, Indexing and Structured Investments" - Gunzberg said that several factors contributed to make commodities more attractive so far this year.

Through February, the S&P GSCI index is outperforming the S&P 500 for the first time since 2007, she said.

Backwardation is back, which is a positive for investors.

Positive factors

"Reduced quantitative easing and falling inventories have driven a return to backwardation where supply shocks are positively impacting commodities," she said.

Backwardation, the opposite of contango, is a term used in the futures market to describe a downward sloping forward curve, which occurs when the price of a commodity for future delivery is lower than the spot price.

The curve shape allows for a positive yield when contracts are rolling, which means that they are selling at higher price than they are being bought. When the opposite happens (contango), investors see their returns eroded by the negative roll yield.

Other positive factors include the impact of supply shocks, which is driving down correlations between commodities and correlations between commodities and other asset classes, she noted.

In addition, rising inflation and rising interest rates continue to represent a positive environment for commodities.

"These factors are leading to a 'perfect storm' for a potential commodities comeback in 2014," she said.

Commodities-linked notes issuance has declined on a relative basis over the past two years, according to data compiled by Prospect News.

In 2009, 2010 and 2011, the asset class represented more than 11% of the total for each of these years issued in the United States, excluding exchange-traded notes. By 2012, their relative size decreased to 8.36%. The asset class made for only 5.22% of the total volume last year. So far this year, notes tied to commodities account for only 3.44% of the total.

Meanwhile, the Dow Jones UBS Commodity index is up nearly 8% this year while the Dow Jones industrial average is down 1.4%.

The cycle may be switching

"Since many private banking clients like to bet on a directional view, there was little demand for commodities in structured product over the past few years post the financial crisis," Gunzberg told Prospect News.

"That may be changing as commodities are now outperforming stocks and as the cycle may be switching."

As equity rallies lead the economic cycle, companies use some of the capital that they raise on commodities to produce more goods for further growth, she explained.

"That demand might be driving a commodities trend, sparking a new interest in allocations through structured products," she said.

"In 2014, the combination of fears over rising inflation, interest rates, and shortages driving lower correlations and higher returns are a perfect storm for a trend in commodities that may be desirable for structured product clients that like to take directional bets."

"A small allocation to commodities may go a long way in providing inflation protection. Investors using structured products may now find commodities attractive to offset growing costs in their everyday lives. One dollar of commodity investment has historically provided as much as $15 of protection," she said.

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