Tracker Bonds - Summary

Brendan, it doesn't seem that you got much of a response to your call for volunteers. Maybe this will get the ball rolling.
Do what you will with what follows.
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What is a tracker bond?
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All tracker bonds are fixed period/term products. Generally three to five years seems to be the norm. Tracker bonds offer a "capital guarantee" where your "investment is secured". They generally guarantee that you will get a certain percentage (often 100%) of your money back at the end of the term no matter what happens. Finally they offer some upside generally as a function of some financial instrument such as the price of a basket of shares, a stockmarket index or some such. They will generally state the upside as a percentage (e.g. 80% of the return of the Dow-Jones index or 100% of the return from a basket of 20 "carefully" selected shares) or place a cap on the upside (e.g. the return on the FTSE-100 capped at 20% per annum).

What are the selling points?
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Obviously, the package can be made seem very attractive to the many people who find the idea of there even being a chance of losing money on an investment unappealing. Tracker bonds seem to offer a magical solution; you get stockmarket like returns but none of the downside.

How do they work?
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There are two components to a tracker bond and your investment is split between them. The first bit is a straightforward fixed term deposit. This provides the guarantee. For example, imagine a five year tracker bond; if the bank or institution can get 3.3% per annum on a fixed term deposit, they can put 85% of your money there knowing that after five years of compound interest the 85% will have grown to 100%. Thus no matter what happens the rest of your money, you'll get your original investment back.

The rest of your money (besides fees) buys a call option on the underlying financial instrument. This is a bit more difficult to explain. The fixed term bit of the investment has analogues in many other retail products (like post office savings certificates for example) but options are generally not marketed directly to the public by financial institutions. This is because they have not traditionally been seen as investment products as they are not expected to provide a return over the long term. Instead they are used in finance to "hedge" (or insure against) things happening in the market. Like insurance, the payout can be very big compared to the size of the premium but more often than not you don't get to make a claim and you "lose" your premium. It is this effect which allows a 10 euro investment in options return 20 euro (a 100% return) if the underlying only moves by 10%. However the downside is extreme - you lose the lot (a 100% loss) if the underlying index even moves 1% the "wrong" way.

The web site for the Chicago Board Options Exchange, www.cboe.com, lists the current prices for all the options traded on their exchange. They trade options on all sorts of things as well as shares such as the value of the Dow-Jones index, etc. and this is a good starting point if you want to understand the technicalities of options which would be prudent if you're going to be investing in them through a tracker bond. Note that you can buy these options directly if you have a US stockbroker.


So what's the bottom line?
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To evaluate whether a tracker bond makes sense as an investment you need to think past the "bundling" associated with these products. Given that you can achieve the same investment results by putting most of your money into a fixed term deposit and spending the rest on call options, you should ask yourself how suitable each of these investments are on their own. Most financiers would not consider buying options to be an investment.


Why are many people on this site very negative towards tracker bonds?
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There are many reasons to dislike tracker bonds. The most fundamental is that, from a financial point of view, tracker bonds are not expected to create a return for the investor. Unlike shares or property, options have a negative expected return. Anything which over the long term would be expected to lose value cannot be a good investment.

Another point of contention is that trackers are marketed in an deceptive way. Like the lottery, the marketing often emphasises the size of the potential return while subtly suggesting that you're not risking much and carefully avoiding the fact that the probability of you getting a return is small. Banks and financial institutions love them because they can make good money on trackers and at the end they have a good spiel for the customer no matter what the outcome. Customers are unlikely to raise hell because the losses will be limited for each individual customer.

Re: Key Post: Tracker Bonds - Summary

Trackers are inferior to direct equities insofar as no dividend income is paid.

It should also be mentioned that a tracker is likely be less attractive in a very low interest rate environment (even a long term deposit will provide only a small amount of buying power to purchase the option).

In a period of rising interst rates (such as we have now) they are likely to become more attractive.

Re: Key Post: Tracker Bonds - Summary

I dont fully understand where the actual return is calculated. So none of the investment is actually in a stock market? If it is a 3 yr tracker bond, is the return from the actual 'tracking' going to be the return of the specified stock market over those 3 yrs? For example, if the bond has a 100% capital guarantee and was tracking the NASDAQ, if the NASDAQ returns 15% from the date of purchase of the bond to the date of maturity, is this the amount of bonus return?

Re: Key Post: Tracker Bonds - Summary

conorobeirne said:

For example, if the bond has a 100% capital guarantee and was tracking the NASDAQ, if the NASDAQ returns 15% from the date of purchase of the bond to the date of maturity, is this the amount of bonus return?

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It all depends on the terms & conditions of the bond in question. Some offer full participation in the tracked index. Some only partial. Some average over a period of time before maturity. Some cap returns. And so on. When looking at tracker bonds you need to be really careful to read and understand the terms & conditions to know what sort of returns are possible.

Re: Key Post: Tracker Bonds - Summary

but is that the basic idea, terms & conditions aside, that the bonus return is the amount that the stock exchange (that the bond is tracking) returns from the date of purchase to the date of maturity? ...even though none of the deposit has been invested in that stock exchange.

Re: Key Post: Tracker Bonds - Summary

conorobeirne said:

even though none of the deposit has been invested in that stock exchange.

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This is not the case. In simple terms what they do is put some (most in the current relatively low interest rate climate) of your money on deposit so that at the end of the term it has earned enough interest to top it up to 100% (or whatever nominal capital guarantee is offered) and then the rest is invested usually by way of an option linked to the tracked index/assets rather than direct share investments.

Re: Key Post: Tracker Bonds - Summary

Yes, I understand the structure...it's the actual Return from the TRACKING that I dont.

For simplicity, lets just say that on the date of purchase of the 3 yr 100% capital guaranteed tracker bond which is tracking the NASDAQ, the NASDAQ was trading at $1000.

85% of deposit has been placed with a bank offering fixed rate 5%, therefore the 100% capital guarantee is safe. 10% used to purchase an option, the rest taken as initial charges etc..

On the date of maturity, the NASDAQ trades at $1500. An option was purchased by the bank to buy at $1300 at the date of maturity costing 10% of sum deposited...Is the bonus return on the tracker bond, terms & conditions aside, going to be 50%(500/1000,return of NASDAQ over 3yrs) minus 10% = 40%?

Re: Key Post: Tracker Bonds - Summary

Or is it 50% (500/1000) - 15%(200/1300)=35%.

Or is it 15%- 10(cost of option)%

or just 15%

...or are they all wrong!!

Re: Key Post: Tracker Bonds - Summary

Hi conorobeirne. I don't visit here as often as I used to do so I missed your question. I dunno if you're still around to read this but here goes anyway.

There is no simple answer to your question as option pricing is a complex subject. Many short term options are traded on an exchange so their prices are established that way. Many long term options (which would be used for tracker bonds) are sold OTC (over the counter) rather through an exchange. The sellers of these options use very complex mathematical models to price them.

As a general rule, the price of options reflect an expectation of future volatility (in the way the price of a share reflect an expectation of future profits) - options are more expensive when the price of the underlying is more volatile. There is no simple relationship between movements in the price of the underlying share and movements in the price of the various types of options on the share.

Therefore the returns which can be offered for the option part of a tracker bond depend on the market conditions when the bank is setting up the tracker. Sometimes the "multiplier" will be greater, sometimes less.

As an aside, I am currently reading Frank Partnoy's book about working in derivatives in Morgan Stanley and came across he gave in 1997. In it he describes selling structured notes, described in finance speak as a zero plus an option, which are exactly the same as tracker bonds; he claims there is never a good reason to buy such products. He was talking about institutional investors like pension funds, trusts, treasury departments, etc. If they don't make sense for big institutions, they certainly don't make sense for small Irish retail investors, in my opinion.

Re: Key Post: Tracker Bonds - Summary

Recent posts have highligted some ingrained prejudices on AAM against TBs and so, 4 years later, I am responding to the original Key Post on the subject.

darag said:

What is a tracker bond?
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The rest of your money (besides fees) buys a call option on the underlying financial instrument. This is a bit more difficult to explain. This is because they have not traditionally been seen as investment products as they are not expected to provide a return over the long term. Instead they are used in finance to "hedge" (or insure against) things happening in the market. Like insurance, the payout can be very big compared to the size of the premium but more often than not you don't get to make a claim and you "lose" your premium.

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Unfortunately a little knowledge can be a dangerous thing (I am not pointing at you Darag). Everyone seems to be aware of this engineering but it is almost irrelevant and is very badly misinterpreted. The retail bank prefers to unbundle the proposition, keeping the most it can as a deposit, and offloading the risk element to a specialist investment bank. Ultimately though this product is not backed by options but is a dynamic investment in the underlying equities mixed with bonds. Typical equity participation is 50% which belies the popular assumption (over interpreting the engineering) that about 80% of a TB is "inert", 5% is taken in charges and only 15% is actively invested.

So what's the bottom line?
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To evaluate whether a tracker bond makes sense as an investment you need to think past the "bundling" associated with these products.

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I have argued above the exact opposite. People seem obsessed with the unbundling into deposit + option. They should look past this unbundling to the ultimate investment strategy, which as I have stated would be a mixed investment broadly 50/50 in equities/bonds dynamically managed to ensure the capital guarantee.

Given that you can achieve the same investment results by putting most of your money into a fixed term deposit and spending the rest on call options, you should ask yourself how suitable each of these investments are on their own. Most financiers would not consider buying options to be an investment.

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Fundamentally disagree. An option is very much an investment, with a positive expected return like any other investment, but with a most skewed payout profile.

Why are many people on this site very negative towards tracker bonds?
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There are many reasons to dislike tracker bonds. The most fundamental is that, from a financial point of view, tracker bonds are not expected to create a return for the investor. Unlike shares or property, options have a negative expected return. Anything which over the long term would be expected to lose value cannot be a good investment.

Click to expand...

This is quite incorrect and since this is a Key Post I feel I must correct it albeit 4 years late. A call option is an investment with a positive expected return. But as argued above we should move away from this obsession with the intermediate mechanics of "passing of the risk parcel" from the retail bank to the investment bank.

Another point of contention is that trackers are marketed in an deceptive way.

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Some are, absolutely agree. The main scope for deception is in constructing highly artificial "indexes" which allow big numbers to be quoted which simply are remote. I have an example posted to me just the other day. The index is made up of the performance of 20 shares but capped at 32% and then tripled, allowing very juicy numbers to be quoted all over the place. The trick - each constituent of the 20 share index is capped at 32%. This basket has next to no chance of making that figure.

Banks and financial institutions love them because they can make good money on trackers and at the end they have a good spiel for the customer no matter what the outcome. Customers are unlikely to raise hell because the losses will be limited for each individual customer.

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A couple of points here. Yes, bank staff do feel much more comfortable recommending capital guaranteed products than open risk ones. Is that a condemnation? After all, bank investment customers are almost by nature risk averse.

Banks make money on TBs. Yep, they are not charitable institutions. But the really relevant point is that because TBs lie between deposits and managed funds the charges and commissions lie similarly midway. TBs generally do not pay high commissions. So rather than note that banks are the main seller of TBs, note the dog that doesn't bark - brokers would much prefer to sell conventional investment bonds with a 3.5% upfront commission and 0.5% per annum trailer.

Re: Key Post: Tracker Bonds - Summary

There is a good [broken link removed]in today's Sunday Business Post by Paul McCarville and Joe Mottley of Clarus Investment Solutions on guaranteed investment products.

While the article highlights the counterparty risk as a feature of these bonds, it does not highlight sufficiently that these are not subject to the government guarantee whereas deposits are.

However, it makes the interesting suggestion that a purchaser of the New Ireland recent "Secure Advantage" product would need to pay 3.5% per year to buy protection for this bonds. They reckon that the investor would be better off buying the subordinated Floating Rate Notes which trade at 50% to 80% of par.

Brendan

Ok, as a less frequent visitor these days, I missed the Duke's posting above.

I disagree with your criticism Duke. It was hard enough explaining how these products work (which seem mysterious - how can you get stock market like returns without risking your capital?) without going into the technicalities of how investment banks hedge exotic options. It is not a demonstration of a "little knowledge", it was an attempt to explain the return profile and sketch the mechanics of how these products are put together by retail banks using examples of the simplest and most understandable financial instruments possible. I'm well aware retail banks don't buy LEAPS and zeros.

The retail bank prefers to unbundle the proposition, keeping the most it can as a deposit, and offloading the risk element to a specialist investment bank.

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An how does this contradict my claim that most of your money buys a fixed term deposit and the rest buys a call option? I mentioned nothing about whether the option was bought OTC or in a market or whether they were vanilla or exotic. I certainly didn't think it relevant to discuss how such options are hedged by their writer.

I also strongly disagree with your claim that that buying call options provide a positive EV. You could at least have qualified the claim with the proviso that your opinion on this matter would be considered unconventional, to say the least, instead of making the claim bold as if it were common knowledge or well accepted fact when the opposite is the case.

I'll admit the original posting was not intended to pass the scrutiny of someone who knows how the industry works - the target audience was very different and so I may have cut a few corners in that regard. The mechanics were background information - the message was intended to explain the return profile. If required, I could easily change a couple of words while leaving the overall message completely intact.

Can principal-guaranteed products (such as tracker bonds) help an investor better manage portfolio risk? [broken link removed] explains that principal protection would certainly be attractive if it were free. Unfortunately for investors, it is not.

There are some potential problems with principal-guaranteed products such as counterparty risk and lack of liquidity during the investment term

Before purchasing these investments, investors should consider portfolio solutions that are more simple, transparent and cost effective.