Bipolar Bonds

Index-linked instruments a schizophrenic investor could love


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 1/4, 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.) One cutting-edge structure is called a Telecom Pairs account, an actively managed portfolio that seeks to profit from observed technical trading patterns of domestic telecommunications stocks. The idea is to profit from inefficiencies by shorting the three top-performing telcos and buying the three laggards on a quarterly, rolling basis. It's a slick mean-reversion strategy that any investor smaller than a hedge fund would be hard-pressed to replicate.

The MPDs aren't continually offered, so once issued they can't be readily acquired, though J.P. Morgan will purchase them back over the counter. But the firm is flexible and will try to accommodate customer demand.

Comments Stephen Berenson, a J.P. Morgan managing director: "If a client articulates an investment idea, we can turn it into an MPD for [that person] or make that client an anchor" for a larger offering. It was by this route that the firm rolled out a five-year Nikkei play and one based on a basket of U.S. retailing stocks.

So, if you've got a few million to sink into a new account and have a nuanced market bet in mind but want a money-back guarantee, Morgan's phone lines are open.