Commodity booster notes, the latest product on the principal protected note shelf, just might be the thing for clients interested in getting in on the action in commodity markets.

The clients’ initial investment is guaranteed — as it is with other PPNs — and in this case return is linked to the performance of a basket of commodities. But, under certain circumstances, that return can be “boosted” beyond the actual performance of the commodity basket. If the commodity basket rises in value, the client would benefit to the stated “boost” level or 100% of the gain, whichever is greater. Should the commodity basket fall, the investor’s principal would be returned at maturity.

However, the way in which these notes work may be difficult for some clients to follow; as well, secondary markets may not be as developed as clients expect. Advisors should ensure clients have a solid handle on the products before investing.

“These investors typically favour exposure to commodities without taking currency risk. They also want an attractive minimum return with full upside potential if the commodities appreciate, and principal protection should the commodities fall in value,” says François Helou, managing director and head of financial products marketing at Toronto-based RBC Capital Markets.

Arguably, this is an appealing structure for investors who are optimistic about the long-term upward trend in commodities, but have reservations about investing in this volatile sector and the potential for downside risk and loss of capital.

“Commodity markets are traditionally volatile and potential returns might vary significantly from year to year. With this in mind, the commodity booster notes are designed for investors who are bullish but probably uncertain about investing in this sector,” says Raj Lala, president of Gibraltar Consulting Group in Toronto.

Currently, RBC Capital Markets and Gibraltar, a subsidiary of Toronto-based Jovian Capital Corp. , are the only two firms that have launched booster notes.

RBC Principal Protected Commodity Booster Notes, Series 1, which recently closed, is linked to a basket comprised of a 10% weight in crude oil and a 30% weight each in copper, nickel and zinc. RBC launched Series 2 of the note in April.

Gibraltar Enhanced Commodities Deposit Notes, Series 1, issued by Montreal-based Société Generale Canada, with headquarters in Paris, France, is linked to a basket comprised of 10% oil, 25% aluminum, 30% copper, 10% zinc and 25% nickel.

The principal of both notes is guaranteed by the respective issuers. Each note has a term to maturity of five years, which is shorter than the terms of other note structures that typically range from six to eight years.

Booster notes use an option-based strategy, which links a zero-coupon bond to an option on the underlying basket of commodities. The zero-coupon provides for the principal guarantee at maturity. The returns provided by the booster structure are based on three clearly defined scenarios. If, on the maturity date of the PPN, the return of the underlying basket is:

> greater than a predetermined level (the boost), the PPN would return the full appreciation of the underlying commodity basket plus principal;

> between 0% and the boost the PPN would return the booster amount plus principal;

> less than the initial level of the underlying commodity, the PPN would return the principal.

The boost for the RBC Series 2 note is 55%, while the Gibraltar note has a boost of 50%.

In the first scenario, if at maturity the valuation of the basket is greater than either 55% or 50%, investors would receive the actual return. That is, if the return of the RBC or the Gibraltar note is, say, 65%, investors would receive this return. Effectively, they would participate in the full upside performance of the notes, a feature that makes the booster structure attractive, compared with structures that have a ceiling on performance or those that use an averaging formula to determine returns at maturity.

In the second scenario, the RBC note would pay a return of 55% at maturity once the percentage change in the underlying basket is greater than zero, while the Gibraltar note would pay a return of 50%. For example, if the return of the underlying basket is 1%, investors would receive 55% in the case of the RBC note and 50% for the Gibraltar note.

@page_break@In the third scenario, if the return of the basket of commodities at maturity is negative, investors would get their principal back.

This is the investment risk of all PPNs. But, unlike structures such as constant proportion portfolio insurance, which utilizes a dynamic allocation between an equity account value and a bond account value, and may subject investors to being “cashed out” prior to the PPN maturity date (if the markets decline significantly), the returns provided by the booster structure are determined at maturity. This is typical of options-based structures.

Put simply, the return of the booster PPN is based on the sum of the returns of each commodity in the underlying basket, multiplied by their respective weights and determined at maturity. The return of each commodity in the underlying basket, expressed as a percentage, is based on the difference between final value and initial value of that commodity. The “enhanced” yield offered by booster notes, reflected in their high potential return, is based on a simulation of forecasted returns for a hypothetical note, using historical returns of each commodity in the underlying basket.

For instance, a simulation of forecasted returns of a hypothetical note conducted in conjunction with the creation of the Gibraltar note, using historical returns of each commodity in the underlying basket and the results of 3,195 hypothetical notes issued between Jan. 1, 1990, and March 30, 2002, indicate investors have a 28% chance of getting full participation and a 27% chance of receiving a 50% return at maturity.

Higher costs may be associated with more exotic PPN structures, but there are no ongoing MERs attached to the booster note. It goes without saying, however, that structuring, transaction, legal and other costs are embedded in the note’s structure, but such costs are typical of all PPNs and similar products.

RBC and Gibraltar notes do not have direct foreign currency exposure. Their returns will be measured in their respective currencies, such that foreign exchange rate fluctuations will not directly affect the amount payable at maturity. All returns are payable in Canadian dollars. Both notes pay advisors a 4% selling commission. Minimum investment in each note is $5,000.

Gibraltar intends to maintain a secondary market — from issue date to maturity date — for its booster notes through its sister company, JovFunds Management Inc. RBC will also maintain a secondary market. But, as neither firm can guarantee the sustainability or liquidity of such a market, the resale price of the notes on the secondary market could be below issue price.

Both Helou and Lala believe the booster structure will be well received by advisors and investors because it addresses desired characteristics such as a shorter term to maturity and potential for unlimited returns. The fact that RBC has issued Series 2 of its booster note indicates a good reception for the structure. Lala says commodities provide “one of the most attractive areas of investment today based on rising global demand and continuing depletion of supply.”

Given recent volatility of the commodity market, he notes, many analysts and investors are uncertain of the market’s direction in the medium term. “Booster notes,” he says, “remove some of the guesswork from commodity investing.” IE