Den of The Lion Investor

I saw this article in the newspaper yesterday. The headline reads:

Bond insurers want $171b of risk cover written off.

The story is that banks have purchased (from bond insurers) quite a large sum of credit default swaps (CDS) to protect themselves against collateralised debt obligations (CDOs) defaults.

Faced with downgrades and heavy financial pressures, the bond insurers are talking to banks about writting off the CDS they have sold to the banks.

Many companies with exposure to such insurance deals have already wrriten down the value of such deals.

Merrill Lynch has one of the largest exposures, with US$18.8b in asset-backed CDOs as at 28th March 2008.

Some US$1.34b was written down in the fourth quarter of last year and the first quarter of this year.

Citigroup has an exposure of US$10.5b and US$1.5b was written down in this first quarter.

You might probably have seen advertisements for the Merrill Lynch Jubilee Series 8 Notes recently.

(If you haven’t, you can download the product fact sheet at the link below:)

Merrill Lynch Jubilee Series 8 Notes Fact Sheet

The Jubilee Series 8 Notes promises 3.15% p.a. for a period of 2.5 years. It also offers “100% principal protection at maturity*“.

A 3 year government bond is currently giving only a yield of 1.86%, so this looks like a good deal.

But wait, we need to read the fine print first (Did you?).

It says:

The Notes are principal protected if held until the Maturity Date. However, redemption of the Notes at 100 percnt of the principal amount of the Notes is not guaranteed if the Note is disposed of prior to maturity, or the Note is redeemed early due to taxation or other reasons.

A lot of people will probably be thinking: “As long as I don’t sell it before maturity, I will get 100% of my principal back.”

Let’s read the finer print and disclaimer on the fact sheet.

The security for the Notes will comprise certain securities issued by Merrill Lynch and the swap arrangements relating to the Notes including the guarantee by Merill Lynch as the swap guarantor. In the event that Merrill Lynch is unable to make or procure payment of amounts due under the securities or the swap arrangements, Jubilee Global Finance Limited will be unable to make the corresponding payments due under the Notes and the recourse of investors is limited to the realisation of the securities and to the termination payment (if any) due to Jubilee Global Finance Limited under the swap arrangements.

Yes, the Notes are 100% principal protected if held to maturity.

But no, the decision as to whether to sell the Notes or not does not lie totally with you.

There are certain conditions whereby the notes can be redeemed by the issuer prior to maturity date. They are:

1. There is an event of default under the Notes
2. The securities backing up the notes are repaid early for any reason, for example because there is an event of default under the securities or for tax reasons
3. The swap agreement is terminated early
4. The Cayman Islands imposes taxes on the issuer or on payments under the Notes which the issuer is unable to avoid

When any of these events happens, there is a risk of significant loss of capital.

A look at the Jubilee Notes Pricing Statement shows the securities backing up the notes to be SGD-denominated notes issued by Merrill Lynch & Co., Inc under its US$110,00,000,000 Euro Medium Term Note Programme. As the Securities are unsecured, they represent long-term unsecured debt obligations of Merrill Lynch & Co., Inc.

Therefore, you are paid the extra yield by taking on the credit risk of Merrill Lynch. And the few other reasons listed above which might not be too exactly transparent. For example, what are the factors that will determine when the swap agreement be terminated? We don’t really know unless we take the trouble to read thoroughly the base prospectus and pricing statement.

The question is, are we being compensation sufficiently to take on all these risks?

You might want to read page 6-12 of the Jubilee Notes Pricing Statement to understand fully the risk factors involved in puchasing this product before deciding whether it is suitable for you. While it has been marketed aggressively as a “100% principal protected product upon maturity“, it certainly isn’t a principal protected product.

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Yesterday night, I attended a talk organised by Merrill Lynch on one of their latest products, China Participation Certificates. According to the information on the brochures, the Certificates are a cost effective way for investors to obtain access to selected China-themed sectors, based on the research of specialised Merrill Lynch analysts.

The session begun with a presentation by Mark Matthews, a strategist at Merrill Lynch. Mark’s presentation was on the outlook for China. His views on China were very positive, with some of the following reasons given:

• High growth rate
• Urbanization still has years to run
• Growth in fixed investments and exports
• Accelerating consumption
• Increasing domestic liquidity due to export earnings
• Strength of Reminbi will keep CPI down

Well, I certainly wasn’t expecting a negative outlook given that the objective of the seminar was to promote their China Certificates.

The next speaker after Mark was another Mark, Mark Wang. He’s the director of the financial products group in Merrill Lynch. Mark gave the overview on how the certificates are created.

Using Merrill Lynch research, specific China themes are selected and SGD indices will be created based on them. The corresponding Certificates which track those indices will then be created, placed out to investors and traded on SGX.

According to Mark, investors are often overwhelmed with an ocean of financial information and it is quite difficult for them to choose the correct sector to invest in. They are also increasingly looking for securitized investment ideas.

Using Merrill Lynch’s Certificates, investors can now get access to top-notch research ideas. These are the sectors that have been selected by Merrill Lynch and their reasons for doing so:

China Water

• Global population growth and increased demand for water supply
• China has the world’s largest population
• As water resources become scarce, the value of water will rise
• Beneficiaries will be companies which collect water from end users, operate in affluent regions with relatively high returns, and specialise in water conservation/purification with marketable products or technologies

China Brands

• Major consumption boom coming
• Rising middle class and Generation Y will propel demand for branded goods
• Increasingly homogeneous market

H-Shares Discount

• Constructed based on the stocks likely to benefit from a growth in the China economy
• H-shares trading at a discount to their corresponding A-shares are purchased

S-Shares

• Constructed based on the stocks likely to benefit from a growth in the China economy and listed on Singapore Exchange

The last speaker of the session was Wong Kok Fai, the director of Merrill Lynch’s equity structured solutions. Kok Fai gave us a more detailed explanation on how the Certificates were supposed to work.

The Certificates are listed securities with 100% exposure to the underlying index. They are Bermudan style warrants (early exercise option available) with a zero exercise price and 1-1 conversion ratio. As such, they have zero gearing and no time decay factor.

With a three year expiry date, they are meant as medium to long term investments.

There is a passive management style as they simply track the index. The annual management fee is 1% and all the dividends paid out by the stocks are also paid to the fund managers.

Even though the Certificates has an early exercise option, most of the retail investors will probably not need to use that option as they can just sell them on the market. Merrill Lynch will be the market maker and provide accurate quotes for the prices.

And with that, the session ended with everyone rushing for the refreshments. Even the originally scheduled Q & A session was cancelled and we were told it would be held outside informally.

My take on this product?

I find the 1% + dividend payout as fees a bit on the high side for a ETF sort of product. This makes it unattractive to me.

However, if someone wants to invest in China via unit trusts, this might be a viable alternative.

Before I left, I interviewed one of the other attendees Jackson on his views about the session and this is what he had to say:

“The food was alright, and the water-melon was quite sweet. But everyone seemed to be rushing to queue for the food.“