Articles

Written by Emma Trincal, The Prospect News  |

November 12, 2009

RBC notes tied to SGI Smart commodity index: long/short seen as tool to mitigate negative roll

Details

New York, Nov. 10, 2009 - Royal Bank of Canada's protected notes linked to the SGI Smart Market Neutral Commodity may offer investors a way to reduce the negative impact of the rolling cost of the underlying commodity futures contracts, a constant source of worry for investors in commodity index-linked notes, sources said.

Royal Bank of Canada plans to price zero-coupon principal-protected notes due Nov. 28, 2014 linked to the SGI Smart Market Neutral Commodity Index (USD - Excess Return), according to a 424B2 filing with the Securities and Exchange Commission.

The reference index created in December 2008 by Société Générale follows a long/short, market-neutral investment strategy which tracks a deemed long position and a deemed short position in various commodity indices.

The payout at maturity will be par plus any gain in the index. If the index falls, the payout will be par.

Cautious investing

"Using a long/short versus a long-only commodity index as the underlying is a good idea," said Matthew Bradbard, president of MB Wealth in Fort Lauderdale, Fla.

"In my opinion, we're in a secular commodity bull market but nothing goes up in a straight line. The flexibility to be able to go short on commodities is invaluable. As a trader myself, I go long certain commodities and short others," said Bradbard.

Rolling

Reducing costs in order to enhance the index performance is the raison d'être of the SGI Smart index, according to the filed preliminary pricing supplement, which says that the strategy is designed to "take advantage of potential inefficiencies in the 'rolling' mechanism used by the component indices."

Commodity indexes track commodity futures contracts that need to be constantly replaced, a process called "rolling." Existing contracts are sold and replaced by the next available expiring contract in a constant effort to avoid physical delivery of the underlying physical commodity. The expiring contract is sold and that the sale proceeds are used simultaneously to purchase the next contract.

If the cost of buying the next contract is higher than the cost of selling the expiring contract or nearby contract, the market is said to be in contango. This situation reflects a so-called negative roll yield. The opposite situation, called backwardation, generates profits due to a positive roll yield.

Cutting rolling cost

According to the prospectus, the long components of the underlying SGI Smart index "use several rolling mechanisms, "dynamic," "seasonal" and "static two-month forward," which aim at improving this roll yield."

Brad Zigler, research analyst at Hard Assets Investor, said that it makes sense to use a long/short commodity index to mitigate the risk of a negative roll.

"Long-only commodity indexes always represent a cost to investors in contango," said Zigler. "In a market in contango, where the deferred month is trading at a higher level than the nearby contract, rolling is an expense because the long-only index makes you sell the expiring nearby at a lower price and forces you to buy the next contract at a higher price."

Short advantage

But with a short strategy, the losses induced by the negative roll can be reversed, said Zigler. "When you short, you have the advantage of selling the back month and buying back - or covering - the expiring nearby," he explained. "In this case, the short position lets you buy low and sell high."

The SGI Smart index takes short positions in three other indexes, according to the prospectus: the S&P GSCI Energy Index Excess Return, the S&P GSCI Agricultural & LiveStock Index Excess Return and the S&P GSCI Industrial Metals Index Excess Return.

Zigler said that crude oil is one of the commodities that have been the most in contango over the past few months. In that regard, the short position on the energy index is justified, at least right now, he said.

"It looks like they're playing the roll yield and attempting to neutralize the commodity exposure and take advantage of the futures curve," said Zigler.

Market neutral

Another important goal of the issuer, as described in the filing, is to offer investors market-neutral returns. Market-neutral strategies, often employed by hedge funds, aim to profit from both up and down markets, and in this case, the idea is to take short positions on commodity contracts that are declining in price and long positions on those whose prices are expected to increase.

Some risks

The risk section of the prospectus warns that the strategy may not work since the "rolling" methodology is based on historical roll yields and historical performance. Another risk factor is the relative limited history of the SGI smart index, which was established less than a year ago.

RBC Capital Markets Corp. is the underwriter.

The notes will price on Nov. 24 and settle on Nov. 30.