COMMENT POSTED IN MY BLOG:
The risk of the (Pinnacle Notes) is pegged to the credit worthiness of some 5 credit references of double A rating. Eg. UOB bank, Standchart and other financial entities of similar rating.
A credit event occurs should any one of the entities default. The recovery rate is about 40%, ie you get back 40% of your capital.
The risk to consider is or ask yourself can anyone of the entities default.? Eg. can UOB default? It would be terrible and it is not impossible. Consider the probability of that event happening. Almost near zero ......
The callablle feature kicks in after 1.5 years depending on the interest rate prevailing at that point in time. If it is called , capital plus some premium will be returned.
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REPLY:
The risk of 1 entity defaulting is small. But, when you have any 1 of 5 entitles failing, the risk increases by 5 times. It is still small, but it is not that small.
When it fails, you have to lose up to 40%. What do you get for this risk? Just 1% or 2% more a year? Is it worth the risk?
Most investors will be willing to give up 1% for the chance of gaining 40% (instead of earning an extra 1% for the risk of losing 40%!)
As you do not know the change of the credit event, it is not worth taking the gamble. I am sure that the product issuer knows how to calculate the risk better than the small investor!
The callable feature has a cost to the investor that is not clearly understood. It gives the product issuer an opportunity to make an additional profit (at the expense of the small investor).
When interest rate falls, the value of the underlying investments increased. The product issuer can redeem the structured notes at a fixed price, and keep the additional gains as their profit. The small investor has to re-invest the money at a lower rate of interest.
Tip: It is better to invest in a straight forward government bond or corporate bond, and earn an interest rate according to the level of risk.
Of the 5 entities should one default
ReplyDeletethe probability is 20%. But if you look at the entities will you think the probability is 20% Let's say the reference entities are DBS, UOB and OUB,INCOME,Standchart.Mathematically is 20%. But in reality, I don't think you will give it a 20%. You will consider every entity and assess individual credit rating. If they are AA+ rated what do you think of the risk involved.
Is it worth for a risk premium of 2.5-3% above Sibor.
The probability that any one credit reference defaults is not necessarily 1/5 = 20%, whether in reality or mathematically.
ReplyDelete(If there is only one entity, is the probability of defaulting 1/1 = 100%? Definitely not.)
The probability that at least one defaults is 1 - P. Where P is the probability that none of them defaults.
P is difficult to estimate. So we often make the assumption that each credit reference defaults independently.
For purposes of illustration, let say each credit references defaults with probability 1%, i.e. it does not default with probability 99%.
Then P, the probability that none of them defaults, is 99% x 99% x 99% x 99% x 99% = 95%!
If each reference does not default with probability 95%, then P = 77% ! The risk increases dramatically as more credit references are added !!
My friend, who is knowledgeable about financial matters, read the 100 page prospectus in detail.
ReplyDeleteHe told me the following:
* the share price of the five reference entitles (ie UOB Bank, etc) are used to determine the return that is payable on the Pinnacle Notes (according to the formula)
* the credit risk is based on the underlying bonds, which are not the same as the reference entities. These bonds have a rating of AA or higher. The earlier tranches of the Pinnacle Notes are invested in CDO (collateralised debt obligations), which are lower quality compared to corporate bonds.
I find this to be quite confusing.
These products are not for the ordinary investors. These used to be for the rich. Recently they are made available to the ordinary folks because the products available are boring and all the
ReplyDeleteproducts seem to be the same.Exotic products like structured products try to be different in features and benefits. How? by putting together a mix of instruments( eg by securitization or collateralisation)to make it look unique.This is similar to situation in the past when unit trust was first introduced. There was much resistance. Eventually the public understood and accepted it.Instead of buying a straight bond issuers package various bonds as a product with enhanced return.
Yes, I think the resistance to new products is geninue. But I really hope consumers will be buying the product only because there are real benefits, and not due to hype.
ReplyDeleteNow, I just feel that the benefits are unclear and the costs are not transparent.
BTW, I think that the benefit of getting a basket of bonds over a single bond is the reduction of risks with diversification, rather than enhancement of return.
Reduction of risk and enhancement of return can be had by diversification;
ReplyDeletehave a basket of bonds of different duration(risk) and ratings and other supranational bonds.
But isn't the return of the basket increased only because of the inclusion of more risky bonds?
ReplyDeleteDoesn't diversification refer to reduction of non-systematic risk by using a basket of securities?
When several bonds each with the same risk level are pooled together, the overall risk is reduced. However, the expected return remains the same.
Did I get it correctly? Please correct me if I'm wrong. Thanks.