Some investors are waking up from a stimulus-induced malaise andrealizing they don't exactly know what risk they've assumed.

There's a prime example in buyers of credit-linked notes createdby Banco Espirito Santo SA last year.

Investors who bought the securities agreed to protect againstlosses on a 2 billion euro (US$2.68 billion) pool of commercialloans made by the Portuguese bank, according to marketing documentsreviewed by Bloomberg News. That was under the assumption that theystood to get annual returns in excess of 10 percent.

Now that Banco Espirito Santo's finances are unraveling,investors in the Lusitano Synthetic II Ltd. deal are understandablygetting nervous about the specific loans they're guaranteeing. Theyasked for details last month, which the issuer is declining to givethem, according to a July 23 notice on the Cayman Islands StockExchange.

The Lisbon-based lender's sudden fall is a rude awakening forbondholders who've generally been rewarded for delving into theriskiest, most-illiquid securities for the past five years. Theeasy-money policies of central banks across the globe have proppedup debt prices, suppressing borrowing costs so much that investorshave piled on more and more risk to meet their return targets.

A Banco Espirito Santo official responded to emailed requestsfor comment by saying the bank may have a statement later.

Offloading Risk

Credit-linked notes work like traditional bonds with interestpayments, except the principal gets wiped out when losses on theunderlying debt accumulate enough. Such deals, which usecredit-default swaps, have been used as way for banks to raise cashwhile offloading some of the risk tied to the loans they'vemade.

In Banco Espirito Santo's case, investors who bought the 184million euros of synthetic securities agreed to absorb losses onthousands of loans, according to the marketing documents. The noteswere sold with expected returns of more than 10 percent, accordingto a person familiar with the matter who asked not to be namedbecause the talks were private.

It's not surprising the bondholders are now getting jittery.Banco Espirito Santo's finances have quickly come undone. Thelender said May 20 there was a “serious financial situation” at thebank's holding company.

The lender was compelled to raise capital after uncoveringpotential losses on loans to other companies tied to the EspiritoSanto group. The Bank of Portugal said Aug. 3 it will take controlof the bank, leaving junior bondholders with losses.

Holders of the credit-linked notes requested information on July4 about whether their investments were tied to loans extended toGrupo Espirito Santo or any of its affiliates, according to thenotice published on the Cayman Islands Stock Exchange.

They were told that the deal was designed to include a “blindpool” of obligations, and that the bank “is not obliged todisclose, and has not disclosed, the identities of the referenceentities relating to the reference obligations,” the noticesaid.

It can't be good to hear you don't have a right to know whatyou're invested in at a time when it suddenly matters.

The longer low yields continue, the more investors will delveinto risk they may not fully understand in search of extra returns.Brace for more unpleasant revelations when central banks pull theplug on their stimulus.

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