Barclays' inflation long-short note taps sentiment; UBS peak feature not major change, analyst says

By Kenneth Lim

Boston, July 11 - Barclays Bank plc's recently launched offering of principal protected notes offer a relatively low-risk product that taps into growing interest in inflation-linked structures, structured products analyst Tim Mortimer of Future Value Consultants said.

Meanwhile, a peak return feature in UBS AG's absolute return barrier notes may only be a significant benefit for investors in a small number of scenarios, Mortimer said.

Barclays links to new inflation index

Barclays recently launched a series of zero-coupon principal protected notes due July 30, 2013 linked to its new algorithmic inflation momentum switching (AIMS) index.

If the final index level is greater than the initial level, the payout at maturity will be par of $1,000 plus double the index return. If the final index level is less than the initial level, investors will receive par.

The index, which was launched on June 12, seeks to reflect the excess returns available by taking a long or short position in inflation-protected securities issued by the U.S. Treasury based on trends in current and expected U.S. inflation. At any given time, the index has either a short position or a long position in the Barclays U.S. Government Inflation-Linked Bond index. It is rebalanced each month.

The decision as to whether to take a short position or a long position in the index for the next month is made based on a trading signal: If the trading signal indicates that either current or expected inflation is flat or increasing, the index takes a long position in the bond index; otherwise, the index takes a short position in the bond index.

Index not a volatility play

The AIMS index was part of a Barclays initiative to make sophisticated trading strategies more accessible to investors through indexing, Barclays head of U.S. rates client solutions Pradeep Jhanjee told Prospect News.

"For a while now we have had a suite of products that we broadly call Quantitative Index Strategies (QIS) ... we take trading strategies, automate them and offer the associated P/L performance in index form," Jhanjee said. "AIMS delivers such a strategy in the inflation space."

The AIMS product arrives just as inflation is becoming a "germane topic right now," he said.

"Across the board, there's a lot of interest in inflation," Jhanjee said, adding that the markets are in a unique situation where "equally good arguments could be made for inflationary or deflationary pressures."

Inflation products have typically fallen under two categories.

"Either you get a coupon that delivers year-on-year inflation plus a spread or a multiple of year-on-year inflation," Jhanjee said. "The latter structure is a pure play on inflation with no real component. Both structures are equally popular ... Those two forms are behind the popularity spike."

The AIMS index, however, allows investors to benefit regardless of whether inflationary concerns are growing or shrinking.

"Our strategies are robust while being simple and effective," Jhanjee said. "The idea here is to identify an intuition and hence use historical data to see if the intuition played out profitably on a risk adjusted basis. In the case of AIMS, the intuition plays of the relatively small size of the TIPS market vis-a-vis the nominal market, roughly 30 to 1. When there's concern about inflation, the nominal market will move into the TIPS market in force and prices could deviate from fundamentals. An effective signal would have the first mover advantage."

"We've developed a strategy that goes long and short TIPS based upon a signal ... it really doesn't matter what condition the market is in," he explained, adding: "It's not really a volatility index ... [The AIMS index] is really an alpha strategy in the inflation space. Money managers who want to access inflation as an asset class and wish to extract excess returns from it will find AIMS an effective index."

Product rates well

Future Value Consultants rated the Barclays product relatively high based on its assessment of the note's value, simplicity and potential returns, as well as its risk.

"It's priced reasonably and competitively," said Mortimer of Future Value, adding that the product appears to try to play the inflation cycles a little bit.

"It's trying to move in or out of inflationary situations, trying to capture the momentum before it happens," he said.

The product's relatively low-risk rating reflects the principal protection, Future Value said in a research note, and the product will likely appeal to investors who seek a known minimum return at the end of the investment term.

Mortimer also noted that inflation products have become increasingly popular.

"Inflation products around the world seem to be coming back in fashion a little bit," Mortimer said.

UBS peak feature may be slight

A series of UBS zero-coupon notes offers an unusual "peak return" feature, but the benefits of that structure may be slight, Mortimer said.

The principal protected absolute peak return barrier notes are due Jan. 22, 2010 and linked to the S&P 500 index.

If the index never closes above or below its initial level by more than the barrier amount, the payout at maturity will be par of $10 plus the absolute value of the highest positive or lowest negative index return on any trading day during the life of the notes. Otherwise, the payout will be par.

Absolute return barrier notes typically pay the additional amount based on the closing level of the underlying index at maturity, instead of based on a peak level during the life of the notes.

The barrier amount is expected to be 20% to 20.5% and will be set at pricing.

"It's having something, but possibly not a lot more compared to a more standard note," Mortimer said.

The concerns for investors remain the same. As with the more typical absolute return barrier notes, investors benefit if the volatility of the underlying is high, but not so high that it breaks the barrier. The feature, however, benefits investors when the underlying moves closer toward its initial level when the note matures.

"It's probably just a few scenarios like that where this structure would make good on," Mortimer said. "But those scenarios are probably fairly few."

Also noting that the barriers, compared to the volatility of the products, are already quite tight, the feature probably is "not enough to make a huge difference" in terms of the returns and the cost to investors.

"I don't think the feature adds a lot in terms of the option price," Mortimer said.

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