Published October 23, 2009

UOB offer leaves investors with a tricky choice

By CONRAD TAN

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THE 4,000-odd customers who bought units in the Prudential Yield 15 and Yield 20 funds from United Overseas Bank (UOB) must now be wondering whether to take up the bank's offer to redeem the units and make them whole. Unfortunately, the choice - if one is aiming narrowly for an outcome which offers the best possible investment return - is much harder than it appears at first glance.

The bank's offer to redeem the units it sold at their par value, less all yearly payouts to date - or at 88 cents for the Singapore-dollar Yield 15 fund and 82 US cents for the US-dollar Yield 20 fund - gives investors the certainty of getting back the initial sum they invested in the product, without any gains or losses on their investment.

Another benefit of accepting the offer is that investors get their money back now, rather than next June, when the funds mature.

Opportunity cost

Of course, a strict analysis must conclude that they would still be poorer for the interest that they could have earned on the money had it been invested elsewhere, say a fixed deposit, in June 2005, when the funds were launched. But this so-called 'opportunity cost' is surely a secondary consideration when compared to the possibility of losing one's entire investment.

But investors who decide to hold their units until they mature on June 10 next year have a chance of receiving not just the full principal of $1 or US$1 for each fund unit, but the final yearly coupon payment as well.

In that best-case scenario, the total return over five years would be 15 per cent for the Yield 15 fund, which pays a yearly coupon of 3 per cent, and 22.5 per cent for the Yield 20 fund, which pays 4.5 per cent a year. That ignores the effects of inflation.

If investors redeem their units now, the return on their investment - over a period of more than four years - would be zero, assuming that they receive the price offered by UOB, rather than a higher price if the market value of the units is above the offer price when the units are redeemed.

So the $150 million question is, just how likely is it that investors will receive their full principal and the final coupon if they choose not to take up UOB's offer?

Sadly, that is impossible to quantify without making rather shaky assumptions about the likelihood of further defaults among the remaining 'credit names' embedded in the funds' structure.

The repayment of the principal and the yearly coupon payments for both funds depend on how many defaults occur in a reference pool of 100 credit names comprising corporate and government debt issuers, as well as on associated derivative transactions.

So far, 14 of the issuers have failed - 10 of them this year. The recovery rates - which measure how much of the underlying debt is recovered when the issuers fail - for the 10 defaults this year ranged from 3 per cent to 35 per cent.

In the worst case of zero recovery from any issuers that subsequently default, the funds can withstand another nine failures before the principal and final coupon are affected.

The ability to withstand at least nine more failures among the 86 remaining issuers seems comforting - especially since recovery rates higher than zero would imply an even greater buffer - until one observes that 10 of the 14 failures to date occurred in the first six months of this year alone.

If nothing else, the fate of Lehman Brothers, Washington Mutual, the Icelandic government and its banks, and others is a reminder that even a diversified pool of corporate and government entities can collapse like dominoes in a crisis.

Certainly, most major economies - including the United States - now appear to be pulling out of recession. But bankruptcies tend to lag the performance of the broader economy, as firms typically put off the unpleasantness of being officially stamped as insolvent for as long as possible.

The fact that the funds' prices have recovered most of the losses suffered earlier this year - the latest prices as at Oct 16 are 81.5 cents for Yield 15 and 84.2 US cents for Yield 20 - may be encouraging, but they can plunge again just as rapidly if there are further failures.

The sorry mess involving investment products with complicated underlying structures that were popular before the crisis serves to illustrate just how difficult it is to properly evaluate such products.

That requires a sophisticated understanding of probabilities, which those who designed the products would surely claim to possess, though it is unlikely that all the investors who bought the products were similarly knowledgeable. Crucially, any complete assessment of the product's likely investment performance must rest on assumptions about how the underlying credit names behave - specifically their 'default correlation', or how likely it is that if some issuers fail, others would too. Those assumptions have mostly been proven badly wrong in the financial crisis.

Simple way

Here, then, is a simple way of thinking about whether to accept UOB's offer - comparing the best and worst possible outcomes of holding the funds to maturity, with the certainty gained by accepting the offer. If an investor had invested $100,000 in the Yield 15 fund, the maximum extra gain possible if he waits until the fund matures next June is 15 cents a unit, or $15,000.

The maximum possible additional loss if he waits is $100,000 - if enough names default such that the entire principal and the final coupon is wiped out, leaving him with only the four yearly payments of 3 per cent already received.

To get more specific than that, one would need to assess the probability of the various outcomes - which would require assumptions about how likely it is that if some of the remaining credit names default, others would too.

Investors who still have faith that they - or their advisers - can accurately evaluate the probability that nine or more of the remaining credit names will default between now and next June may want to wait for the extra returns - 15 per cent for Yield 15, or 22.5 per cent for Yield 20 - that they stand to gain by holding on to their fund units.

Others should take the money that UOB is offering, lick their relatively light wounds, and sleep all the better for it.