UBS offers principal-protected CPI note; product offers real return potential, adviser says

By Kenneth Lim

Boston, July 16 - Principal-protected notes linked to inflation can be a useful piece in a portfolio that offers real returns, an investment adviser said.

UBS AG plans to price fixed-to-floating rate principal-protected notes due July 27, 2013 linked to the year-over-year change in the Consumer Price Index.

The notes will pay interest monthly at a 3% annual rate in the first year. Subsequently interest will be the year-on-year change in the CPI plus a spread of 200 to 250 basis points, paid monthly. The minimum coupon is zero.

Investors will receive par at maturity.

Real yields

Inflation-linked investments offer the potential to make real returns, which are adjusted for a loss in purchasing power, the adviser said.

"Inflation is like a hidden tax on your investments," the adviser said. "It's always there and if you don't manage it, you could potentially lose money in real-dollar terms. It's a constant battle."

Principal protection is an important aspect of the investment, because a significant risk of losing capital takes away the main benefit of an insurance against inflation, the adviser said.

Reasonable terms

The principal protection is also probably partly necessary not so much because of deflation risks, but because investors can also buy inflation-linked notes in the form of Treasury Inflation-Protected Securities.

"TIPS are obviously much less risky," the adviser said. "If you're selling a CPI-linked structured note, you have to make it competitive risk- and return-wise relative to TIPS."

The 200 to 250 bps spread over the CPI change that the UBS notes offer seems "reasonable," the adviser said.

"I think it's essentially a risk spread over Treasuries," the adviser said. "They have to compensate you for taking on unsecured risk of UBS. Also, if inflation is 5%, I need to buy something that returns 7% to 7.5% in order to match this product. Obviously it's important what you think inflation is going to be."

The four-year term of the product also seems about right, given the current sentiment about the economy. Many investors expect the U.S. economy to begin growing again within the next four years, which should imply inflation, the adviser said.

"I think it's a fair bet that the economy should be recovering by 2013," the adviser said. "The inflation folks think that inflation is going to take off because of all the money that the U.S. is spending or will be spending, and because the economy is still weak the Fed can't fight inflation properly because they don't want to send the economy back down again."

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