Harris to offer year-over-year structured CDs; seen as cost-efficient structure for issuers

By Emma Trincal

New York. Sept 2 - Good economics for issuers of zero coupon principal-protected certificates of deposit may not always be perceived as the best deals for investors.

In a market where principal protection has increased in popularity since last year and where a strong stock market rally since March has fueled investors' appetite for S&P 500-linked products, arrangers are facing rising structuring costs. Banks and investors often need to find a compromise between affordable structures and rewarding investments.

The planned offering by Harris NA is a case in point.

The Chicago-based bank plans to price zero-coupon principal-protected certificates of deposit due Sept. 28, 2012 linked to the S&P 500 index, according to a term sheet. But instead of calculating the underlying index return from the beginning to the end of the term - or "point to point" - the issuer will offer a payout at maturity consisting of par plus the sum of the index returns in each of the three years making up the life of the CDs, in other words, on a "year-over-year" basis.

The year-over-year structure allows investors to lock in a potential return yearly within the cap limit. The return in each annual period will be capped at 6% to 10%, and the minimum payout at maturity will be par. The exact cap is not yet known as it is to be set at pricing on Sept. 25.

Cutting structuring costs

This structure, according to a market source, while not new, may be judicious for issuers facing increasing costs because of the resurgence of U.S. stock volatility, which has pushed up the structuring costs of products tied to the S&P 500 Index.

With equity volatility rising to new highs, investors are asking for more and more derivative products to express their bullish - or bearish - views on stocks. As a result, the prices of the stock options embedded in CDs linked to the S&P 500 index have gone up substantially, said this source.

"Given the popularity of call options on the S&P 500, it is cheaper to use options on a year-to-year basis rather than on a three-year term," he said.

Since the financial market meltdown in September 2008 after the bankruptcy of Lehman Brothers, demand for principal-protected structured CDs has grown significantly, this source said. But with the equity market in rally mode since March, a lot of the demand has been directed towards products tied to the S&P 500 as investors are eager to participate to the market upside while getting principal protection. Structured CDs are seen as a good alternative to money market funds, he noted.

Yet, while those CDs are increasingly in demand, the cost of packaging zero-coupon principal-protected CDs can be prohibitive for the banks, even without taking into account the cost of the embedded option, said the market source. A three-year, zero-coupon CDs currently trades at around 94 cents on a dollar, he said, adding that issuers have to pay on top of this the brokers' commissions and a variety of fees. The volatility of the U.S. stock market makes these costs all the more difficult to manage.

"There are so many ways to create those products to make them attractive to investors, "said this market source. But the year-over-year structure is a way to reduce structuring costs, he said.

'The simpler, the better'

However some investors say what works for the banks is not necessarily so appealing for buyers.

"I like to keep it simple, "said Frederick Wright, partner and chief investment officer at Smith & Howard Wealth Management in Atlanta. "I'd rather have a point-to-point structure than making it complicated like that and having those types of limitations."

Mr. Wright said that the year-over-year structure was not particularly favorable to the investor both on the upside and the downside.

"Assuming the cap is 8% and that on one of the three years, the market goes up by 50%, you're limiting your payout to 8%. That's a lot to leave on the table," he said.

For downside protection, Mr. Wright said that his preference goes to more traditional features.

"We look for more principal protection or alternatively for a greater buffer," he said. His firm last week offered its high-net-worth clients a principal-protected product linked to the S&P 500 with a 20% buffer, he said. "The S&P [500] would have to fall by more than 20% before the investor lose money. And if it fell by 22%, the loss would only be 2%," he said.

Finally, locking in the yearly gains of the underlying index rather than calculating them once and for all at the end of the term, adds more complexity to the deal, Wright said, which is a negative.

"You have to explain the product to people and they may have to explain it to someone else," said Wright. "They don't understand it and they want simplicity. The simpler, the better."

The CDs will settle Sept. 30. Incapital LLC is the distributor.

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