SG bearish notes tied to SGI Bond 10Y index: hedging interest rates with principal protection

By Emma Trincal

New York, Dec. 7 - SG's planned bearish protected five-year notes tied to the SGI Bond 10Y index is a play for investors who are betting that interest rates will go up and who need to hedge their long credit positions against that risk, sources said.

SG Structured Products, Inc. plans to sell 0% bearish principal-protected index notes, series 2009-4, due Dec. 31, 2014 linked to the return of the SGI Bond 10Y USD index. This issuer is a subsidiary of French bank Societe Generale.

The payout at maturity will be par plus twice the absolute value of any decline in the index. If the index gains, the payout will be par, according to a term sheet.

Synthetic bond underlying

Societe Generale is the sponsor of the SGI Bond 10Y USD index. The index is designed to reproduce the performance of hypothetical 10-year bonds sold by a U.S. issuer and paying coupons semiannually. It uses swap and deposit fixing rates instead of actual bonds in order to mirrors the total return of the 10-year U.S. treasury.

"This index is a synthetic bond without the credit risk," said a market source familiar with the sponsor.

Hedging market risk

"This structured product is used as a hedge," said Matt Lloyd, chief investment strategist at Advisors Asset Management Inc., the deal's distributor.

"It's designed for people who need to hedge their bond portfolio on the view that the Fed is going to raise rates in the next five years. You may own bonds, be happy to earn your coupons and unwilling to sell. What you need is a hedge against your loss of principal," said Lloyd, adding that the notes were conceived to provide such hedge.

Lloyd said that the product is being well-received by institutional investors, money managers and registered investment advisers. Some investors may want to use the notes to hedge a high-yield bond portfolio, others for investment-grade holdings, he said. Any fixed-income portfolio subject to interest rate risk may benefit from this strategy, he said.

"The deal is going to be popular because of the rising interest rate theme and the protection. Whether rates go up because of the Fed [Federal Reserve Board] or because of inflation or the dollar does not matter. In all cases, the conclusion is higher rates and a bearish bond market," the source close to the sponsor said.

Targeting durations

Unlike standard bond indices, the SGI Bond index seeks to replicate the exposure to bonds through derivative instruments, according to a bank's summary on the index. One of the interesting aspects of this benchmark is the constant maturity feature, allowing the index to be rolled-over on a monthly basis and reinvested at the corresponding swap rate to match the targeted duration.

"This index is a hedging tool. If you're long credit and short the index, you're hedging the interest rate risk. The interesting part is the constant maturity, which allows you to target a duration in order to be perfectly hedged," said Philip Guziec, derivative strategist at Morningstar.

Cyclical reversal

Investors make money in this investment only when bond prices fall, or when the underlying index declines. Despite the protection of the principal, there is a risk for investors not to earn any payout after five years, as stated in the risk section of the preliminary product supplement.

The SGI Bond 10Y USD index, although launched only in August 2007, has been backtested since January 1990. So far its performance has been positive with an annual return of 11.7% since inception and 8.5% over the past 10 years. If this performance continued, investors in the notes would lose money.

But Lloyd said that investors in the notes are "contrarian" and that they assume that the long-term trend of low interest rates has reached its term.

"We've had a bull market in interest rates since the late 1980s. But this market is cyclical," he said, pointing to the peak and low of the 10-year treasury, which rose to 15.84% in September 1981 and dropped to 2.21% in December of last year.

"This product is based on the path of least resistance," he said, adding that rates are at an all-time low and that "the Fed in the next five years is going to raise rates."

The securities will be marketed through Dec. 28, and settlement is scheduled for Dec. 31. Societe Generale is the agent.

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