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Structured investments: Tap into rising commodity prices

Commodities can help protect against the risk of persistent inflation and a variety of geopolitical shocks. Allocating to a commodity-linked structured investment can enable you to potentially benefit from higher commodity prices, while mitigating the equity-like downside that commodities have exhibited in the past.

Our commodity analysts expect crude oil prices and other commodity prices to continue to rise, with an expected return of about 20% for broad commodities over the coming 12 months. Key drivers include accelerating growth in China, persistent production challenges, low inventories, and ongoing weather risks.

This constructive outlook has been further bolstered by the surprise announcement that Saudi Arabia and eight other oil producers will be implementing a voluntary production cut of 1.66 million barrels per day, effective from May to December. WTI crude oil futures—which had fallen from USD 120 per barrel in June 2022 to as low as USD 65 per barrel in March 2023—have staged a strong rally since the early April announcement but remain well below our analysts’ USD 105 per barrel forecast for May 2024.
To the extent that rising commodity prices continue to put upward pressure on inflation, this trend could lead to further interest rate hikes from central banks. An allocation to commodities could therefore help protect against the risk that further rate hikes would pose to both stocks and bonds. In 2022, faster-than-expected rate hikes contributed to sharp losses for stocks (down 19%) and government bonds (down 12%), while the Bloomberg Commodity Index rallied 16%.

Implementation considerations
While we expect commodity prices to rise modestly from here, a direct investment in commodities could expose investors to significant downside risks if economic growth were to stumble. After all, commodities tend to trade with stock-like volatility, and commodity prices have staged sharp selloffs in previous recessions (WTI crude oil futures even traded in negative territory at one point in 2020).

Therefore, as an alternative to directly investing in commodities or futures markets, investors may prefer to use structured investments. Based on current market pricing, it may be possible to invest in a structured investment that offers enhanced upside potential and contingent downside protection for investors who are willing to lock up their investment capital for 3 years.

In Figures 1 and 2 , we have summarized the hypothetical historical returns of a 3-year structured investment with terms in line with those generally available at the time of writing: 140% of the upside potential of the underlying index, with a 25% contingent downside trigger. With these terms, there are three possible outcomes, based on the underlying index’s return at maturity:

If the index is higher than its starting value, the investor receives their original investment plus 140% of the index’s gain.
If the index is down more than 25% from its starting value, the investor participates fully in the index’s downside, receiving their original investment minus the index’s loss.
If the index is down less than 25% from its starting value, the investor receives their full principal value at maturity).

In Figures 1 and 2 we estimate historical returns assuming an underlying index of the Bloomberg Commodity Index 3 Month Forward—rather than the Bloomberg Commodity Index, which invests by purchasing short-dated futures—in order to reduce the negative impact of rolling futures contracts (see “A note regarding the underlying index” at the end of this report for more details).

Historically, a structured investment with these terms would have outperformed the Bloomberg Commodity Index Total Return (which combines the returns of the Bloomberg Commodity Index with the returns on cash collateral invested in 3-month Treasury Bills) in about 91% of the 5,831 rolling 3-year periods that we analyzed during this period, with an average outperformance of about 7.7% p.a. (25% non-annualized). In the other 9% of rolling periods, the Total Return Index outperformed as the return on the cash collateral exceeded the rise in commodity futures prices.

Important note regarding structured investments
When considering how structured investments could fit within your portfolio, the appropriate amount and type of structures should take into consideration your objectives as well as your willingness and capacity to accept relevant structured investment risks, such as issuer and underlying asset exposure risk, as well as a sacrifice of some liquidity (there is a limited secondary market for structured investments).

In the case of this structured investment, we recommend against using capital that you might need for cash flow needs in the next 3 years, because there is a limited market for selling structured investments prior to maturity. While a structured investment with these terms would offer some protection against mild losses, it is fully exposed to downside risk beyond the downside trigger threshold—because of this risk to the capital investment, we recommend against investing any funds that are earmarked for a specific goal or cash flow need upon maturity.

If you would like to know more about structured investments, and how they might fit into your portfolio, reach out to your financial advisor, who can help you to put these considerations into context. You can also ask your advisor for a copy of our report, Structured investments: Considering outcome-oriented investments, published 23 March 2020.

Content is a product of the Chief Investment Office (CIO).

Main contributor: Daniel J. Scansaroli, Head of Portfolio Strategy & UBS Wealth Way Solutions; Justin Waring, Investment Strategist, CIO Americas

A note regarding the underlying index
One headwind to a direct investment in commodities is the “negative roll yield” that can be caused by investing in commodity markets where the futures curve is in contango (the commodity’s futures are priced higher than the commodity’s spot price). When a market is in contango, investors will tend to lose money when they sell expiring futures to buy the next month’s future. This “negative roll yield” can be a significant headwind to returns when compared to investments that avoid buying short-dated futures. As you can see in Figure 3 , an index that buys 3-month futures would have experienced much less negative roll yield than one that tries to keep rolling short-dated futures to try to keep in line with short-term movements in the spot price.
Source: UBS


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