The Buried USV Option

By Brad Zigler

Friday's March import price figures pretty much told us what we already knew: Stuff is getting more expensive.

The report, however, shouted the news rather than just whispering it. Import costs rose a higher-than-expected 2.8% in March, mostly due to inflation in the price of oil. Street expectations called for a 2.1% price hike.

Imported oil costs rose 9.1% in March alone, but prices were up across other categories as well. Feeds and human foodstuff prices, for example, increased 2.5%.

The great overseas factories that used to export deflation to us are now starting to ratchet up prices. And we're returning the favor in spades, mostly in the agricultural sector. U.S. ag export prices climbed 4.1% in March. All together, it's a lovely round robin of inflation.

Despite the surprise to economists, traders shrugged off the import news. The gold market, typically a barometer of inflationary expectations, sold off in the morning COMEX floor session, following the lower tone in the overnight market. June gold, at last look, was off nearly $6 per ounce from yesterday's settlement after bumping against overhead resistance at the $938-$939 level.

Silver, too, is lower. The May COMEX delivery dropped 45 cents to $17.59 by mid-session, falling through weak support at $17.67.

Still, it hasn't been a bad week for precious metals. Basis the London AM fixes, gold rose 2.2% and silver notched a 2.9% gain, bringing the gold/silver ratio in a bit to 51.6-to-1.

A new way to exploit the gold/silver ratio emerged this week when a new silver exchange-traded note was floated by UBS under its E-TRACS marque (NYSE Arca: USV).

Silver investors now have an analogue to the Deutsche Bank gold ETNs that were launched in February (you'll recall we recently ran an illustration ["Can Silver Outperform Gold (Again)?] of a gold/silver ratio trade using the DB Gold Double Short exchange-traded note [NYSE Arca: DZZ] combined with the iShares Silver Trust [AMEX: SLV] grantor trust).

There are some distinct advantages to holding ETNs rather than grantor trusts. First, the accounting is much easier. Grantor trusts sell off vault holdings to pay operating expenses, so holders have to recognize the tax consequences of these sales. The tax rate on gains, too, can be onerous: 28% on long-term holdings.

ETNs, as zero-coupon debt obligations, don't create a tax consequence (at present, at least) until they're liquidated. Gains are subject to taxation at a maximum 15% for long-term holdings.

Ordinarily, that'd make the USV note a pretty good candidate for pairing up with the DZZ note a gold/silver ratio position.

Think twice about that, though. Notwithstanding the present illiquidity in the USV market, there's a contingent call buried in the note. The issuer, UBS AG, can redeem the note, starting in April 2013, if the outstanding float falls to $10 million or less. In essence, that makes a purchase of USV the equivalent of writing a five-year European-style covered call against the underlying note's Bloomberg/CMCI index.

This may not affect current pricing of the note much, but as time passes, the impact of the embedded option will be increasingly felt, especially if the note struggles to gain market share. And what are the odds of that in the burgeoning world of ETNs?

Gold/Silver Ratio 

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