Wednesday, November 14, 2007

Trigger Happy

Accepted wisdom as the moment is that whenever Wall Street investment banks invent a new "structured product" or "special product", it's just a new way to separate us fools from our money. That may be true in general, but once in a while Wall Street comes up with something which might be useful to us mortals.

Among the recent offerings are derivative debt securities with a term of a year or so and a "trigger price". The idea is that if the underlying stock drops below the trigger price at any time during the lifetime of the derivative, the issuer can put you the stock or pay you a cash its cash value. If the underlying stock doesn't drop below the trigger price, you get the full principal at maturity. In either case, you also get a coupon, and often a large one.

At the moment, when reasonably safe debt securities have yields which are very low and decreasing, and stocks demand steadier nerves than many investors have, some of these strange derivatives look like good deals.

Two days ago I bought some Citigroup Funding ELKS 8.50% Linked To Chesapeake Energy, known to their friends as ECC. Unless the price of CHK, the underlying security, drops below $24.62 between March 23, 2007, and the redemption pricing date, the third trading day before the maturity date of April 4, 2008, Ecc will return the full principal at maturity, in addition to the remaining coupon. Since CHK has been above the trigger price since the pricing date, this means that ECC will return full principal as long as CHK doesn't drop below $24.62 between now and April 1, 2008. At the moment, CHK is trading at $38.90, S&P rates it a Buy with a 12-month target price of $47.00, based mainly on their guesses about the natural gas market, and MSN's mysterious (but free) quant gadget called StockScouter calls CHK one of the "10 stocks for right now". I would guess that that's about as safe as you're going to find today with an 8.5% coupon.

If ECC is such a good deal, why is Citi offering it with such a high coupon? First of all, when they issued it on March 27, 2007, they knew less about the future prices of CHK than we do now, when more than half of that future is past. Secondly, Citi needed more money to invest at a time when money was hard to come by, so they had to offer a good price to get it. Third, as the fixed-income professional who introduced me to "special products" suggested then, the investment banks probably issue them as part of a straddle: it doesn't bother them too much if you get a good deal; their own profit is from the vigorish anyway.

So what are the main risks of ECC? One is that CHK could indeed crash, perhaps as the result of a general stock market crash, or the bursting of a commodities bubble, or a recession which drives down commodities prices. Or Citigroup Funding itself could become insolvent - not as unthinkable now as it was a few years ago.

If you like the concept of these trigger price derivatives, but don't like ECC, you might want to look at AHY, whose risks and possibilities are both different.

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