Wells Fargo's CDs tied to CMS yield curve offer safer bet on inflation but still have risks

By Emma Trincal

New York, April 19 - Conservative investors anticipating that long-term interest rates will continue to be higher than short-term interest rates may be attracted by Wells Fargo Bank, NA's planned certificates of deposit linked to the yield curve, sources said.

However, the capped annual interest rate and call feature should be carefully examined by investors, they noted.

The CDs will mature April 30, 2022, according to a term sheet.

The yield curve will be the spread of the 30-year dollar Constant Maturity Swap rate over the two-year dollar CMS rate.

Interest for the first year will be 8%. After that, the rate will be four times the yield curve minus 25 basis points, with a floor of 0% and a cap of 8%. Interest is payable quarterly.

The payout at maturity will be par.

The CDs are callable on any interest payment date beginning on April 30, 2012.

Inflation fears

A source said the 8% interest rate for the first year is "attractive."

As long as the yield curve remains steep, investors can expect to earn the CMS spread minus 25 bps multiplied by a leverage factor of four and subject to an 8% cap, according to the term sheet.

As a result, the optimal CMS spread for an investor would be 2.25%, as this level gives investors the 8% maximum annual interest rate they can expect after 25 bps are subtracted and leverage is employed.

"Right now, the spread is already at 3.35%, so it's capped," this source said.

"But the deal is very popular because people are betting on an even steeper curve," he said.

"People bet on inflation, so they see long-term rates rising. On the other end of the curve, they bet on the government keeping interest rates low because the government needs the banks to stay afloat in order to make loans. People believe that the government will keep the yield curve artificially steep for a long time to come because it benefits the banks," this source said.

8% premium

Investors get principal protection because the instrument is a CD covered by the applicable rules of the Federal Deposit Insurance Corp. But sources said that it does not eliminate all risk.

One aspect of the risk for investors is that Wells Fargo has the ability to call the CDs anytime after two years, effectively limiting the maximum return investors may expect to get on their investment.

"That's the risk. There is an early redemption risk. But it's one of the things that make the trade work. If there is an early redemption, investors still get their 8% coupon on the first year," this source said.

"The CDs could get called for a number of reasons. It could be due to the funding spreads of the bank, or it could be induced by different anticipations in the forward swap market," this source said.

Right now, however, the market expects the swap curve to be inverted in six or seven years, he said.

"If the market is right, obviously the CDs won't get called because the issuer wouldn't have to pay a coupon after six years. But if things change and if all of a sudden there are more calls on inflation, then yes, it is more likely to be called. That's the risk. And that's why you get your 8% on the first year," he said.

Tough call

Howard Simons, president of Rosewood Trading, questioned the timeliness of making a bet on a steeper yield curve given how steep the curve currently is.

"The yield curve is extraordinarily steep and will stay steep for a while, but who knows? History goes in cycles, and if the curve is steep for a while, it probably is going to get flatter and invert," he said.

Short call

Simons looked at the 8% coupon on the first year and saw it as the equivalent of a premium offered to the writer of a call on the yield curve.

In his view, investors in the CD are betting that the yield curve will increase, hence are holding the equivalent of a long position on the curve. At the same time, the cap is the equivalent of receiving a premium when one writes a call on the curve.

Investors are also betting that the yield curve will not get wider than 2.25%, which is the yield curve needed to attain the 8% cap given the subtraction of the 25 bps and the four time leverage factor.

"You're asking somebody to write a short call while they own the yield curve," said Simons.

"I'm giving up gains. I'm writing a call against what I own, giving up the upside" after 2.25%," he said.

Pricing the call

"The question is whether the 8% coupon compensates you enough. I don't think so," said Simons.

"If you look at the shape of the yield curve historically, it spent much of its time greater than 200 basis points. I'm pretty sure you'll get capped away. Plus it's callable, so if the curve goes in the right direction for you, the call goes against you."

In addition, Simons said that market consensus is not leaning toward more steepening of the curve at the present time.

"It's hard for the market to anticipate that the curve is going to get steeper than it is. So right now the general opinion is that we have to get flatter because short-term rates will rise, unwinding the carry trade," he said.

"The 8% on the first year is attractive, but after that it probably is not. You're asking investors, at a time when the curve is at a record steep, to bet on further steepening. And if it gets steep, it gets called away from them," he said.

The CDs will price on April 23 and settle on April 30.

Incapital LLC is the distributor.

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