Index-linked instruments a schizophrenic investor could love

By Michael Santoli

For all its success in cloning sheep, the science of biotechnology hasn't yet managed to cross-breed a bull with a bear, a project that even if pulled off would offer little besides gamy steaks or cattle that hibernate. But the stock market, which has plenty of sheep itself, generates herds of bull-and-bear hybrids, infused with both a hunger to profit from gains in share prices and an acute fear of downside risk.

Investment bankers, alas, have seized on this to craft the perfect pitch for such bipolar investors - investments that let you soar with an up market but that cushion any fall in a Wall Street slump.

Ranging from special certificates of deposit to notes listed on stock exchanges, these engineered instruments have become popular with investors who believe there might be more profits already in the books than in the future. Such a belief is no doubt spreading these days, as the Dow Industrials and S&P 500 gallop higher to new records despite the Asian financial crisis and a slowdown in U.S. corporate earnings.

Wall Street houses such as Merrill Lynch, Salomon Smith Barney and others have for a few years been stamping out retail securities that pay the investor some percentage of any increase in a stock index - often more than 100%, sometimes a bit less - but guarantee that at least the original stake will be returned at maturity if the market slides. The only peril of buying such items is limited to the opportunity cost of not having stashed the money in risk-free Treasuries. There's also the marginal credit risk attached to the highly rated issuing companies, since the notes are, in fact, debt capital borrowed rather cheaply by the firms. The brokers make a buck on the deals through commissions and occasionally by charging a premium over the current index level.

The simplest members of this investment family are notes tied to the major U.S. stock indexes. Merrill, which calls its versions MITTS (for Market Index Target-Term Securities) has listed several on the S&P 500 and one on the Dow Industrials. The Dow MITTS, sold in December, were priced at $10 each and will deliver 100%, of any rise in the benchmark average above 8594 until January 2003. All MITTS, aside from a few sold back in 1993, ensure complete principal protection. Some longer-term issues even guarantee a small profit above that.

In the past 18 months, Salomon Smith Barney has issued three equity-linked notes whose returns are tied to the S&P 500's performance. Currently, the firm is marketing its first note that will track the Dow. The S&P-linked securities, $200 million worth in all, also pay no interest. But after maturing in five years, they deliver a portion of the index's appreciation, ranging from 102.25% to 110%. "It's not a trading instrument. It's a very conservative, buy-and-hold investment," says Salomon Smith Barney's Ed Watson.

Still, these securities can be bought, and sold at any time. They're listed on the Chicago Board of Options Exchange (others are on the New York and American stock exchanges). And while turnover tends to be light, they trade with an efficiently thin spread between the bid and offer prices. But because the market has been so strong the past three years, buying one of these notes long after they're issued means the investor doesn't get full downside protection.

For example, one Salomon Smith Barney note issued last March, symbol YSB, was recently quoted at 18 l/4, up 22% from its $15 issue price. So purchasing it now will get you some potential upside, but because only $15 is guaranteed at maturity, the downside risk is $3.25 ($18.25-$15), or about 18%. For this reason, the brokerage houses tend to roll out fresh versions every so often.

It should be noted that an investor can fashion the same investment terms at any time, with full downside protection, by purchasing a combination of unit-trust shares on the S & P or Dow (traded on the Amex under the names Spiders and Diamonds) and a long-term put option on the same index. But that requires a heftier cash outlay and is far more complicated than calling a broker to secure $15 MITTS.

The same note structure is used as the platform for more sophisticated and tailored market plays. A Russell 2000 note has traded on the Amex since September for small cap players. And several firms have sold securities tracking Japan's Nikkei index, which in recent years has made the appeal of downside protection painfully apparent. One attraction of playing the Japanese market this way is that the returns are "dollarized," meaning the investor takes on no currency risk.

Merrill has sold MITTS based on an index it constructed to track the performance of stock markets outside north America. The so-called Major 11 International MITTS - a one-stop, leveraged globalization bet - runs to December 2002 and will pay 115% of any increase in the index over that time. There's a similar issue, based on a CBOE technology index. For the very sophisticated and well-heeled, J.P. Morgan offers some pretty fancy CDs. Called Market Participation Deposits, or MPDs, they reflect the newest ideas coming out of the bank's equity-research and derivatives groups. Sold through Morgan's private banking unit, where it takes a seven-figure deposit to open an account, the CDs are offered as 100% or 90% principal-protected (as dictated by the customer's risk tolerance). Potential upside varies accordingly. The bank also will sell real cowboys a straight call option on any market bets it devises.

No straight index-linked CDs are offered, because the firm sees no way to add value to such vanilla products. Instead, there is the European Financial Restructuring Basket, for one, a collection of 15 banks and insurers picked as likely beneficiaries of the deregulation and consolidation enveloping the Continent. The 100% principal-protected version, which is free of currency exposure, is up 12% or so since its issuance in October (Incidentally, the minimum investment in MPDs is $100,000 too high to be government insured, though smaller such CDs - like one recently offered through a Merrill subsidiary - have their principal insured. But the Triple-A rating on the ultimate issuer - Morgan Guaranty Trust - should let investors sleep soundly at night.)

Courtesy Barron's
The Dow Jones Business and Financial Weekly

Plunging blue chips - attractive long term buys

Colombo's stocks, on a continuing downward trend, have taken a particularly heavy beating in the last three months, even the blue chips and the attractive plantation sector. Colombo's index - the All share Price Index (ASPI) has plunged by 82 points or 17 per cent and the plantation index by 33 points during the third quarter of 1998.

Heavy foreign selling has been the main cause of the decline, a CT Smith Stockbrokers' quarterly analysis reports. Colombo's foreign exposure is now at one of its lowest since liberalisation, the report said.

There has been a significant foreign outflow, which has led to foreign portfolios dropping to all time low. This has led to a situation where a market is under owned means that its below the average holding level of particular markets. Hence, the foreign owned stocks mainly the blue chips have taken a beating.

The market recorded a net outflow of Rs. 187 mn for September compared to an inflow of Rs. 44 mn in July and an outflow of Rs. 164 mn in August, they say.

Overall the ASPI fell by 100 points in August and remained largely flat in September.

Heavy foreign selling in higher capitalised blue chips in the banking and finance sector, manufacturing and diversified sectors contributed to the decline of the index during the quarter, they added.

Low sentiments in the plantations, with concerns over the impact of the recent Russian economic crisis on tea prices, resulted in plantation stocks plunging.

Trading volumes were thin and the average daily turnover in September was recorded at Rs. 42 mn down from Rs. 74 mn in July and Rs. 65 mn in August.

The poor sentiments largely due to the continued foreign selling pressures, prompted by persisting currency and economic woes, has caused foreign investors to both reduce portfolio exposure to Asia and liquidate positions to meet redemption's.

But foreign selling pressure is showing signs of receding, with recent cuts in US interest rates and a gradual restoration of stability in the regional markets, CT Smith Brokers say.

Presently capitalised at only Rs. 97 bn, the market is currently at its lowest level since 1991.

Despite a forecast, corporate earnings growth of 10 per cent to 15 per cent for FY 1998/99E (downgraded from 20%+), the prevailing uncertainty in regional and world equities markets is expected to keep foreign investors on the sidelines.

With domestic investors also being cautious, it's unlikely to see any significant and sustainable gains in the indices in the short-term.

Endorsing a common view the research unit of the brokerage says that with key blue chips trading at extremely low levels, the market offers very good long-term value.

Tea and Tourism drop

Export revenues and volumes of tea have dipped in August on a YOY basis.

Volume and revenue fell by 8.2 per cent and 5.9 per cent YOY respectively. In rupee terms though there has been an increase of 2.8 per cent in revenue for this period, a JHK release for August said.

However cumulative figures from January to August 1998 has recorded an increase of 19.4 per cent in revenue (US$) and a 3.7 per cent increase in volume YOY.

The Russian crisis has resulted in export volumes to Russian and the Commonwealth of Independent states (CIS) declining 10 per cent for the month of August compared to July this year. They expect a further decline in export volumes to this region from September to December, the report said.

This is mainly because many exporters of tea to Russia have been hard hit due to non payment on past shipments, are reluctant to further expose themselves. In addition, the crisis has also resulted in this basic beverage costing three times more, resulting in lower imports by Russia, the report said.

They expect the Middle Eastern countries to offer the greatest prospects for future Sri Lankan tea. The Middle Eastern countries for the same period imported 50 per cent of Sri Lanka's tea for august 1998, while Russia and the CIS importing only 20 per cent of Sri Lankan tea. Meanwhile the tourism sector continued on its downward trend for August recording a decline of 1.8 per cent year on year. Compared to the average of 5.4 per cent for the previous four months of 1998. Cumulative figures from April to August dropped by 4.4 per cent year on year, the JHK report said.

South and East Asian regions continued to lead the way in the decline recording declines of 13.9 per cent and 30.7 per cent respectively. The only relief for the sector coming from Western Europe (WE) which recorded a 8.9 per cent growth. This comes after July's growth rate of 0.8 per cent. The cumulative figures for the period for WE recorded an increase of 7.3 per cent, the report said.

Cumulative figures from April to August recorded an average growth of 7 per cent. However with a growing trend of avoiding stopover stays in Colombo, together with a sluggish business guests market, Colombo city properties have suffered an average drop of 7 per cent in occupancy for the first four months of 1999, dragging down overall occupancy growth, the report said.

JHK's projections of an increase of 9 per cent for WE has not changed for 1999. They expect a 23 per cent drop in Asian arrivals for 1999. Overall tourist arrivals for the financial year 1999 is expected to drop by 1 per cent year on year.

If you were the Finance Minister

Managing Director, Hatton National Bank Rienzie Wijetillake:

The tax relief/tax holiday culture has to be changed. This has not brought results. A lot of untapped resources are available in the rural areas. There are plenty of savings available in the outstations. Steps should be taken to draw out this sector on a large scale and divert saving into concrete investment in the villages.

A few investments in major infrastructure projects in rural areas have meant little money trickling down to the villages as a way of savings.

As a banker, I have found that unlike in the past, villagers are not expecting subsidies. They are prepared to work for their upliftment, what they lack is an opportunity to do so.

If the government had created more economic activity over the last few years, we would see more money generating as savings. If the savings base is large, we don't need to depend on foreign resources. We need to tap our own natural resources like water, power and turn them into economic activity, for instance, the Mahaweli which generated employment economic activity.

Economic activity has stagnated now. There are enough of skilled people in the outstations. Government should introduce large projects at macro levels like highways, telecommunications, which will in turn generate macro economic activity in the outstations.

Government has given incentives but they have not filtered to the villages. The villagers want opportunities to do something of their own. The villagers would not benefit if there is no opportunity for growth to do some work.

General Manager, Seylan Bank, Mrs. Rohini Nanayakkara :

"A banking sector is the catalyst of any financial sector. As such, I would attempt to strengthen the banking sector.

As a banker I am supportive of the government's measures to strengthen the banking sector via monetary and fiscal measures.

However we require a healthier investment climate. We need more incentives for investment. There seems to be a lack of investor confidence both foreign and local. Government policies must be consistent and build confidence among investors despite the on-going war. I suggest that local investors should be encouraged with the same liberalised tax-free incentives offered to the foreign investor. Most of our local clients complain of unfair disadvantage over foreign investors.

How a tax-free or low tax climate for local investors would impact government revenue has also to be considered. But an overall better climate for investment would promote economic growth and a corresponding growth in the banking sector.

The banking sector plays a critical role in economic growth.

While I support prudential banking regulation, too stringent policies may destroy or impede the growth of a developing economy. However lessons must be taken from the Asian financial crisis also, to strike an effective balance.

Capital Markets Sector,

A leading financial services Director said,

We need to develop a long-term vibrant debt market. All these days, equities have been taken as a role model. Certain companies think that equity is the cheapest form of borrowing, which is not the proper way to go about.

Earlier we used to think that the stock market was the barometer meter for sourcing foreign funds. When the foreign funds began to pull out we have found that this is not so accurate.

Even the industries that are starting up use short-term funds for long term investments, which carry a higher interest rate. Long term lending rates should be made attractive for new industries to emerge on the long run. The savers are also getting a raw deal. They should have easy access to government securities and corporate debt, which would give them a higher yield than the bank deposits. In terms of poverty alleviation, it's important to educate the saver to prevent them from getting a negative return.

In developed markets, the debts are traded in greater volumes than equities. A rating agency for local debts and a sovereign rating for dollar denominated debts is also needed.

The Central Bank and the Monetary Board are very enthusiastic about this issue.These things are essential if Sri Lanka is to develop a vibrant secondary debt market.

Assistant General Manager (Treasury)-DFCC, Mangala Boyagoda:

"The biggest problem in this country is that successive governments have not been committed for long term projects. They want short-term results for political gains. As a result, infrastructure and long investment are neglected in this country. We need consistent government policy towards development," Assistant General Manager (Treasury) DFCC Bank, Mangala Boyagoda said.

Sri Lanka is an ideal place as a financial hub. We have to capitalise on it by developing off -shore financial activities like insurance, shipping and banking. For instance, the Singaporean government offered a concession that any company willing to set up their head office, the state would give tax incentives. Deutsche Bank took the plunge and moved their regional office there. We need to do things like this to develop offshore financial activities, "he said.

Plantation Sector

Planters Association

We are at present witnessing some disturbing events in the financial and economic environment. Natural rubber prices in the international markets have plummeted and most rubber producers, including the Regional Plantation Companies (RPCs), are experiencing negative producer margins.

The tea prices at the Colombo auction, which have already been adversely affected, are now bound to stagnate if not fall further.In view of the above, it is predicted that profitability of the RPC will be reduced substantially compared to the high level of profitability enjoyed during the last two years.

The declining corporate profitability will also result in delaying the capital development programmes of the RPC.

Since most RPCs are listed on the CSE, the overall stock market index will also be affected due to low earnings anticipated during the foreseeable future.

GST has created a negative impact on the cost of production, as RPC's are unable to claim the GST charged on their inputs. It is suggested that an appropriate scheme be devised to enable the RPC to claim GST on their inputs.

Tea and rubber producers are currently in the exempt category and are therefore not able to claim their input taxes.

This burden has increased cost of production by about Rs. 20 to 25 mn per year per company and pushes the cost of production by up by about Rs. 2 to 2.50 per kilo of made tea.

The most significant payments of GST in the plantation industry are in respect of power, packing materials (tea chests, tea sacks etc) and tea, rubber, coconut and oil palm machinery.

For instance, a company producing 10 mn kilos of tea per year will incur an electricity bill of around Rs. 40 mn on which the GST payable will be Rs. 5 mn. Similarly, the same company will spend around Rs. 40 mn on the purchase of packing materials, incurring GST of another Rs. 5 mn.

Tea and rubber manufacturers are subject to GST on machinery, which is an enormous burden and nullifies the duty free facility afforded on tea machinery. Corporate taxes: We request that all tea and rubber manufacturers be taxed at 15 per cent.

Import duties: In addition to our request for the waiving of import duty on rubber tapping knives and rain guards for rubber trees, we request this facility to be extended to the following: motorised knapsack sprayers, motorised tea harvesting machines, motorised tea pruning machines, motorised tea and rubber uprooting equipment (winches, monkey grubbers etc), motorised holling augers, and oil palm harvesting poles.

With the shortage of labour and the need for the plantation industry to be more productive, we must make use of modern technology that is now available to the industry and such items being imported duty free will assist us in our endeavours to uplift the industry.

A senior banker who did not wish to be named had this to say:

Being the finance minister I won't cut down on the budget deficit and money spent for infrastructure projects.

The government's plan is to try to bring down the budget deficit at the expense of infrastructure. More funds should be channelled for roads, power and water supply. You need to create the right environment for people to do it. If you don't do it now the cost of doing it will treble in 5 years' time.

The state must invest in infrastructure projects. If we don't invest, the purchasing power of people would decrease. The private sector doesn't have money so state has to do the infrastructure work. Let the private sector manage it. Government can build but can't manage, whereas the private sector scores on these things.

The conception that the private sector is the engine of growth is rubbish. The private sector wants everything from the government. Private sector has taken more incentives, BOI concessions to get duty free BMW's and tax incentives to line their purses, but have contributed very little towards economic development.

Hence, it is essential that the government too looks into the needs of the economy.

The two state banks could be merged and developed to establish a branch in every region. A holding company could be established in Colombo to manage the regional branches and give them additional strength.

The funds mobilised in the region should be used for the development of that region. Today banks go to the rural areas to tap the money, but bring the money to Colombo. This concept should change. A synergy could also be used by using one region to develop another.

As we are moving towards globalisation, a strong banking system is essential. The financial needs should be regional as well as global. Bankers must look at broader concept.

Without infrastructure we cannot expect sound development. Government must spend on development.

We must move away from national way of doing things. For instance, incentives for government employees have not changed over the last 25 years. The system should be re-formulated so that annual incentives are based on inflation and merit.

Only then can we talk about productivity. If people are poorly motivated the country will not march forward.

Thinking too has to change. For instance, people dodge paying for their radio licences as it is cumbersome to up at the post office. If the collection system is streamlined by adding the charge to your domestic rate tax and you can do away with the licence. This will make it easier for people to pay and the government is assured of more revenue coming in.

Minimum interest rates for savings He emphasised the need for a minimum interest rate for savers if the domestic savings base is to be increased. The Central Bank can enforce a minimum rate through the Banking Act, even the finance minister can do it. India has a minimum interest rate for domestic savings. "We have control led price for essential items so why not for savings?" he said.

The state sources funds through the local debt market, but utilises the money for unproductive things. They are mostly used for consumption, in order to get political gains. The monies raised should be channelled for development.

Finance companies sector

Managing Director, LB Finance, Naomal Soysa

A factor that will affect the cost of financing of small businesses which rely on capital from finance companies would be the improved recoveries on defaulting loans. This process could be expedited by having an efficient legal system where undue delays are shortened.

Finance companies sector, Bandula Sirimana

•Hire purchase and leasing of motor vehicles is the core business of finance companies. The introduction of GST has increased this cost, placing an unreasonable burden on our customers.

This is the only 'second hand business' on which GST is being charged. This sector should be exempt from GST.

•Banks are now raising funds at 14.2%. Finance companies are compelled to raise funds at a higher rate. This problem can be solved by giving finance companies access to soft loans at low interest.

•Finance companies are only allowed to raise funds by operating fixed deposits, which are costly. Therefore finance companies should be allowed to accept savings deposits.

Ceramics sector

Royal Fernwood (Pvt.) Ltd: Managing Director, Jagath Peiris, -

The ceramics sector has good potential in the market for tableware, but are unable to compete with imports. This is because the rupee is over valued. The rupee should be re- valued to show a realistic value. There should be healthy competition, not competition that would kill the market. Technology used by the Sri Lankan companies should be improved so it could be more productive. But the cost is extremely high. The government should give subsidies and provide finance to acquire new technology. Customs duty should be brought down so that we could compete with the imports. This will also mean more exports.

As it is the government cannot provide the sector with subsidies because its defence expenditure is on the rise. A solution is for this is if the government brings down the duty on the sector, there will be more exports, which would to bring in more foreign exchange, which the government can use to finance the military expenditure.

G.M Royal Ceramics: M.S.W.Fernando

The government in the previous budget reduced the rate of rebate given to the ceramics manufacturer who exports ceramics product.

The rebate contributes to a large part of our profit. If something is not done, (if the rebate rate is not increased) we will be wiped out of the export market.

Executive Director, Lanka Ceramic Ltd: Mahinda Perera

The government in its 1997 Budget took a step in the right direction in considering the Ceramic Sector as a 'trust' industry entitled to certain fiscal and tax benefits. However, for these benefits to be fully exploited by companies in the industry, certain other factors should be considered.

They are:

• Lack of a government policy to develop human resources in the ceramic trade. To be competitive particularly in the export market, companies require skilled personnel to produce quality products whilst maintaining high levels of productivity.

• The mineral resources used as raw materials in the industry are finite deposits which are not replenishable and, as such it is of a national importance to ensure that maximum value addition is gained for the nation.

•This can only be achieved by the use of advanced technology in the mining process which will provide a high level of productivity, extraction of the maximum possible quantity of the valuable material (i.e. minimising waste) and use of environment friendly mining and processing methods.

•Large scale producers of ceramic products in the region continue to 'dump' their low quality products at give away prices which draws on our valuable foreign exchange and in some cases prevents the government of getting tax revenues due to malpractices such as under invoicing in the import trade.

•This is in addition to seriously affecting the local industry which has to compete on an uneven playing field.

Given the above issues, it is our view that the government should consider the following remedial measures to develop the ceramic sector.

•To provide fiscal and tax benefits for the formation of a technical training institute to develop skills and competitiveness of the human resources in the ceramic industry through planned professional training.

•There are professional institutes of this nature in developed countries which are interested in supporting a venture of this nature.

•Providing fiscal and tax benefits to companies engaged in the mining and processing activities to use technologically advanced equipment and environment friendly methods.

•To implement non-tariff controls and anti-dumping legislation to ensure that minimum quality standards are maintained on imports to the country to protect the consumers and ensure that the nation gets 'value for money'.

More Business * Dubai Drydocks will refit "Cossack Pioneer" * Atlantic Service upgraded * Marseilles approved as coffee storage port * Diploma in Shipping Port Agency * Nittsu prepares for freer market in Indonesia * Evergreen invests in QEQ development * Korea to open door to foreign carriers * New computer system for Kuala Lumpur Airport soon * Exporters prefer Singapore * Stock exchange essay contest * Seven flights to Male * NDB in Galle * SIA unveils KrisFlyer * Luxury cruises for Conqueror users * IGATEX will upgrade garment industry * Winners of BQS awards * Sri Lankan wins prestigious American marketing award * Benefits of ISO 14001 certification

Business contents page