Financial institutions in the U.S. are set to pull in billions of dollars of business providing capital guaranteed funds backed by over-the-counter swaps with insurance companies. Both Deutsche Bank and Salomon Smith Barney are working on products that will use derivatives with insurance companies to provide guarantees, according to officials at both firms. Jean-Marie Barreau, head of fund derivatives at Deutsche Bank in London, said the market could grow from around zero now to USD5 billion in the first year and USD10-15 billion the following year.
Whereas in Europe guaranteed funds have traditionally been structured with zero-coupon bonds and a call option on the underlying equity market, guaranteed funds are a relatively new product in the U.S. Financial institutions are turning to insurance companies to provide the guarantee because, in the current low interest rate environment, zero-coupon bonds are too expensive.
In the structure used by Citigroup, two of its subsidiaries enter swaps with Ambac Assurance Corp. to provide investors with their capital back in the event of the net asset value of the underlying mutual fund falling. Citigroup Asset Management buys a guarantee from Ambac and Ambac enters a mirror image of that contract with Salomon, said Ramesh Menon, managing director at Salomon. This leaves the insurer with a flat position and reduces the cost for the fund originator. Menon would not disclose specifics on the instruments put in place to hedge the risk. Deutsche Bank's Barreau said the net cost of the guarantee is usually under 40bps, as the insurance company also pays the fund originator.
Barreau expects to see a lot more of these deals in the U.S. as structured equity products become more popular. "The U.S. market is way behind Europe [for structured equity products], but it is catching up quickly," he said. The reason this structure will take off, according to Barreau, is investment rules in the U.S. stipulate that a guarantor must have a AAA rating and cannot be affiliated to the originator.
An industry lawyer said it is beneficial for the fund originator to have a AAA rated credit in its pitch book, instead of protecting the principal directly via derivatives.
Barreau said the Deutsche Bank product is likely to hit the market before year-end and it has yet to choose a guarantor.
