Monday, September 21

Swap-based ETFs

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Swap-based ETFs are ETFs that aims to tracks indexes by holding a basket of stocks which may be not related to the basket of stocks that makes up these indexes and it enters into a agreement with a counterparty in which this counterparty will deliver the performance of these indexes.

To explain it simply, the objective of these swap-based ETFs, as with all other ETFs, is to track the performance of a chosen index. These swap-based ETFs will hold a basket of stocks. If these basket of stocks underperforms the chosen index, another party will have to make up the difference in this underperformance to the ETF so as to allow the ETF to fulfil its objective of tracking the index. On the other hand, if this basket of stocks outperforms the chosen index, this difference will be paid to the other party since the ETF is only required to track the index. Nothing more or less.

On the other hand, cash-based ETFs are the traditional type of ETFs. Their model is simpler as compared to swap-based ETFs. Basically, they hold a basket of stocks that replicates a chosen index as closely as possible and this basket of stocks is divided into units where it is traded on the stock exchange.

Why is there a need to understand these two types of ETFs ? This is because there is an additional risk between these two types of ETFs which investors will need to know.

For swap-based ETFs, there is an additional risk which cash-based ETFs does not face and that is counterparty risk. For example, one particular swap-based ETF is tracking an index and for this specified time period, the basket of stocks which this ETF is holding on to, underperforms the index by a significant percentage. As such, the counterparty is required to pay this difference. Now what happens if this counterparty is not able to pay up ? This is one issue which investors of swap-based ETFs may have to consider. However, this counterparty risk is limited to a certain percentage of the value of the fund under regulations so the risk is not that high though it will still be there.

Furtheremore, swap-based ETFs tend to have less transparency. Investors may not know the details behind the swaps such as the value of the swaps and the collateral that are being used for the swaps.
















(Taken from Barclays Global Investors)
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Thursday, September 17

Rent a car instead

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Unless there is a need for you to travel long distances on a very frequent basis such as your workplace being very far away from your home, it may not be worthwhile for you to purchase a car. The money that can be saved from not buying a car can be channeled towards investment, which can reap additional profits down the road. However, some of us may wish to enjoy the perks of a car to drive occasionally, such as bringing your family out or going to a rather inaccessible place. Besides the option of buying an off-peak car, which may not be that convenient in the first place, due to the various restrictions being imposed on a off-peak car, one may consider the option of renting a car from a carpool instead.

Renting a car from a carpool has its advantages. Some of the carpools that are available in Singapore includes the NTUC Car Co-op and Whizzcar. Typically, these carpools operate a fleet of cars in car parks which are located in selected locations around the island. For a start, you will have to register with these carpools first. Subsequently, when you wish to use a car for a certain period of any day, you can book that specified period online or through the phone. Once this is done, you can go the a selected car park where these cars are parked in to collect your car and you are ready to drive. If you need to top up petrol, a card will be given to you at selected petrol stations so that the petrol that you have topped up will be charged to the carpool. At the end of the specified period that you have booked in, you will have to return the car.

The charges usually goes by the hour and with each hour, some amount of free mileage will be given to you. If you exceed this amount of free mileage, you will have to pay additional charges which often goes by per km. There may be special packages which are available such as a fixed rate for a 24 hours booking.

Thus the option of renting a car can be cheaper than buying a car if you do not use your car frequently. Furthermore, you will not have to worry about other fixed charges which are associated with buying a car such as insurance, maintenance and loan payments and still be stuck with a depreciating asset.

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Wednesday, September 9

Disability Income Insurance

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For the majority of us, our main source of income is from work. As such, if we are not able to perform our work due to any mishaps such as medical reasons or injuries, this can be financially devastating. Now some of you may think that since they have bought some form of insurance, the insurance company should be able to cover this. However, if you have only bought life or term insurance, you must satisfy the criteria of total and permanent disability which I have covered in an earlier post here before the insurance company will make any payout and this criteria can be very difficult to be satisfied. So what happens if you are injured and you are unable to work ? Are there any insurance plans out there in the market that can cover this gap and provide you with income for the period which you are not able to work ?

The answer is disability income insurance. Currently, only Aviva and Great Eastern have disability income plans and they are known as IdealIncome under Aviva and Paysecure under Great Eastern. Typically, these plans insure 75% of your current income. In the event that your employment income is terminated if you are unable to work due to any injuries or sickness, these plans will kick in to replace 75% of your income after a period of time following the start of any disability. This compensation from the insurance company can be continued up to your retirement age depending on the type of plan that you have bought. Furthermore, if you are unable to achieve your previous income being drawn from your work prior to disability, these plans will also supplement your income after your disability if you managed to find employment.

As such, if you are dependent on your employment income, it will be prudent to take up this type of insurance policy. In my opinion, this is the most important insurance policy one should have besides your medical plan. There are minor differences between the two plans offered by the two different insurers so it will be good to seek the advice of a qualifed financial adviser, who can advise you on which plan to choose.

The opinions expressed by the author in this article is provided for your personal information only and should not be constituted as financial advice. It is recommended by the author that one should seek the advice of a qualified financial adviser with any issues or questions regarding financial matters.
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Wednesday, September 2

Property Bubble

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A few months ago, I gave the view that the property market is likely to come crashing down soon as the property market correlates strongly with the stock market and the economy and the property market oftens lags behind the stock market.

The current property market has taken me by surprise indeed since it has only tumbled slightly not long ago and now it is near its previous peaks again despite of the economic doldrums. As such, I am of the view that the current property market is a property bubble in the making. Why is this so ? Here are some of the reasons below.

1. Divergence of the property market with the economy.
This is rather self-explanatory. The economy is still not booming yet but the property market is near its previous peaks.

2. Packed crowds at condominium launches
This is best illustrated with the example of Optima@Tanah Merah, which is a new condominium. Apparently, there was a queue waiting three days earlier of the actual launch date and they were prepared to wait there for three days.

3. Sky-high prices
With reference to the Optima@Tanah Merah, this project was sold on an average of $810 psf. Casa Merah, which is right behind it was only released at an average price of $588 two years ago. To add on, Centro Residences which is situated in Ang Mo Kio was sold at an average psf of around $1150 and this price are more typical of projects near the edge of the city.

4. Advertisements
I'm not sure if you notice it but on the last page of the Straits Times nowadays, it is always a full page graphic advertisement of a new condominium up for sales.

5. Rock-bottom interest rate
The current SIBOR rate is around 0.7% and this is very near to the all-time low rate of 0.56% back in June 2003. This makes home loan packages to be very attractive to prospective buyers.

As with all bubbles, it will burst eventually. But the question is that when will the bubble burst ? I shall make no attempt to forecast it since it is not crucial to know when it will burst and no one can forecast this accurately. A bubble can last for a very long time just like a bullish stock market can remain irrationally bullish. The most important thing is that one should not pay inflated prices which is way above the true value or worth of any assets or investments.

Thursday, August 27

Figures add up nicely for GE Life

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Figures add up nicely for GE Life
By Larry Haverkamp, For The Straits Times
Taken from the Straits Times , August 27, 2009

GREAT Eastern Life Insurance looks to be everyone’s pick for the most generous company of the year.

The company wants to help its policyholders by buying back their GreatLink Choice (GLC) structured notes. These are similar to minibonds but there are more of them. Minibonds worth $508 million were sold to 10,000 investors, while $594 million worth of GLC notes were sold to 18,000 investors.

If the notes default over the next four years, investors would lose the $594 million they had sunk in. The company says it will lose $250 million by buying the notes back. It looks generous.

Great Eastern will require its agents to pitch in too. They will return the $12 million they made in commissions from selling the notes.

This glowing story has been widely reported. On the surface, it might appear investors would be foolish to turn down Great Eastern’s offer. But that may well be wrong.

GLC comes in five tranches. GLC 1 and 2 make up one similar group while GLC 3, 4 and 5 are another. A Sunday Times report by Ms Lorna Tan correctly calculated that GLC 1 and 2 are safer investments than GLC 3, 4 and 5.

Does that mean the buyback is not in the best interests of GLC 1 and 2 investors? In a word: Yes.

Does that mean the offer would benefit Great Eastern at the expense of these investors? In another word: Yes.

Instead of helping GLC 1 and 2 investors, it would bite them a second time. The first was when Great Eastern sold GLC without disclosing the total returns of the underlying bonds. That is the standard way for structured notes to conceal risks. The public is shown only the investor yields – such as 3.5 per cent to 4.9 per cent annually for GLC. This lulls investors into thinking risks are moderate. They never see the high-risk returns produced by the note’s underlying assets of junk bonds and credit default swaps.

The second bite comes now with the offer to buy back the notes. It will take a safe 17.5 per cent return from GLC 1 and 2 investors and give it to Great Eastern.

Less generous than it appears

BY 6PM tomorrow, Great Eastern will have bought back many of its GLC notes and written them down to ‘fair value’. It says the write-down will result in a $250 million loss. That estimation could help the company sell its buyback offer. Investors see $250 million as a lot of money to turn down.

In fact, Great Eastern’s loss may be much less:

  • First, the $12 million clawback of commissions from agents will go entirely to the company. Investors will not get a dollar.
  • Second, Lion Global was the fund manager for GLC. Its management fees totalled 8 per cent to 11 per cent on the $594 million value for all five GLC tranches. Much of that was paid upfront – and unlike the clawback of agent fees, Lion Global will not be required to return its fees.Lion Global is 100 per cent owned by Great Eastern and OCBC Bank, while OCBC owns 87 per cent of Great Eastern.
  • Third, GLC 1 and 2 are likely to produce high profits for Great Eastern. They make up $209 million – or 35 per cent of the $594 million worth of notes sold.Just over half the investors have accepted Great Eastern’s buyback offer so far. Why so many when it is not in their interest? The current price for the notes is set at 61 cents on the dollar, according to the company website’s pop-up ad and newsletter – a buy-only price, set by the underwriter, which is Deutsche Bank for GLC 1 and 2. Investors who redeem early must sell at that price and sell only to the underwriter. This is likely to bias the price downwards. Great Eastern’s offer is valued at $1 minus the dividends already paid of 10.5 cents. So $1 – $0.105 = $0.895 – easily more than 61 cents. Investors would conclude: ‘It’s a no-brainer. I accept!’ Besides the downward price bias noted above, the 61 cent price on the website is out of date. The more recent price is 73 cents, which makes the offer less attractive to investors. It can also be found on the website, though not as easily.
  • Fourth, GLC 1 and 2 investors must give back 10.5 per cent in clawed-back dividends. They must also forgo the 3.5 per cent that was to be paid at the end of September and October, plus another 3.5 per cent due at maturity in 13 and 14 months. So 10.5 + 3.5 + 3.5 = 17.5 per cent – that is the ‘one year’ return investors will receive if they reject the offer and hold GLC 1 and 2 to maturity.
While that 17.5 per cent yield is high, the risks remain low for two reasons:

  • One, GLC 1 and 2 have underlying collateralised debt obligations (CDOs) that reference bonds rated BBB- by Standard & Poor’s (S&P). Their time to maturity is just over one year. S&P data shows the one-year default rate for BBB- global corporate bonds from 1981 to last year was only 0.6 per cent. That is less than one bond out of 100 defaulting.
  • Two, the rules for GLC 1 and 2 do not place them near default. Only six out of more than 100 bonds held by either tranche have suffered ‘credit events’ in the past four years. Another 11 bonds must go bad before investors lose any capital. With the improved economy, it is unlikely that 11 more bonds will go bad within 14 months.If this scenario plays out and GLC 1 and 2 do not default, investors will get back 100 per cent of their investment in little more than a year. Though there is a slight risk, that 17.5 per cent return more than compensates for it. In its automated e-mail messages, Great Eastern gives the opposite advice: ‘Do not miss this chance to accept the offer,’ it says.

Accept the buyback for GLC 3, 4 and 5

GLC 3, 4 and 5 – valued at $385 million – are different. The underwriter has priced GLC 3 at 36 cents on the dollar, and GLC 4 and 5 at 23 cents. These figures probably understate the value of the bonds for the same reasons as for GLC 1 and 2, but in this case, it does not matter. The value of these bonds is so far underwater – below the buyback price – that some degree of under-pricing won’t affect the investor’s decision.

  • First, the underlying CDOs of GLC 3, 4 and 5 are rated CCC- by S&P. Their time to maturity is three to four years. S&P data shows that the three-year default rate for CCC- global corporate bonds from 1981 to last year was 39 per cent. The four-year default rate was 42 per cent.
  • Second, the CDOs backing GLC 3, 4 and 5 reference more than 100 bonds each. The contract requires that an additional 10, seven and five bonds in GLC 3, 4 and 5 must go bad before investors lose their capital. This is more likely to happen since the time to maturity for these tranches is three times longer than for GLC 1 and 2 and their bond quality is much lower.

There is no need to feel sorry for Great Eastern. The buyback is not as expensive as it seems, even for GLC 3, 4 and 5. The notes are structured as a wager rather than an investment and work like this: Only 10 per cent to 15 per cent of the underlying bonds need to suffer credit events before investors must forfeit the other 85 per cent to 90 per cent of good bonds to ’someone’. That someone is usually the underwriter or arranger – Goldman Sachs for GLC 3, 4 and 5.

Great Eastern could simply inherit this deal from investors. Or it might reduce its risks by first entering into a hedge or re-insurance agreement with Goldman Sachs or others. Great Eastern has not said if it did this although it would not be unusual.

The company’s losses on GLC 3, 4 and 5 would be further reduced by: One, the expected profits from GLC 1 and 2; two, the clawback of agent commissions; three, the management fees earned by Lion Global; four, the profit sharing – if any – with the underwriter; and five, tax savings should losses occur.

Four years from now – when the notes have all matured – the net loss to the OCBC group is likely to be substantially less than the trumpeted figure of $250 million.

The writer is a financial columnist for The New Paper and Adjunct Professor of Economics and Statistics at Singapore Management University.
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