RBC's $44.56 million 8% notes linked to Chesapeake Energy drew large bid but not consensus

By Emma Trincal

New York, March 19 - Royal Bank of Canada's $44.56 million of 8% coupon-bearing notes due March 28, 2014 linked to the common stock of Chesapeake Energy Corp. was a popular deal considering the type of structure, which is usually brought to market in smaller sizes, sources said.

Some of the factors behind the large bid could have been the name itself. Chesapeake stock has risen by 55% since its bottom in May 2012, and many investors are still bullish on the name.

Another factor was the structure itself, which offers a buffer with a final observation as opposed to the more common barrier observable any time during the life seen for most reverse convertibles, they said.

If Chesapeake Energy shares finish at or above the threshold level - 92.9% of the initial level - the payout at maturity will be par of $10. Otherwise, investors will be exposed to losses beyond the 7.1% buffer, according to a 424B2 filing with the Securities and Exchange Commission.

Interest is payable quarterly.

Despite those advantages, buysiders and analysts were skeptical about the trade.

"I don't like it at all," said Dean Zayed, chief executive of Brookstone Capital Management.

"There are many other structures that could give you 8% on the upside with more principal protection than this.

"A 7% buffer with Chesapeake is not enough. This is a stock that can move 5% or 10% in one day. Just today, it's already down more than 5%."

Volatile play

At the close of Tuesday, the stock price was down 5.1% at $21.04.

Chesapeake on Friday announced that it will redeem $1.3 billion of notes early in spite of a legal dispute with its bondholders. On Monday, RBC announced the pricing of the coupon-bearing notes at par.

"The bond redemption didn't have an impact on the stock," said Mark Hanson, energy analyst at Morningstar.

"The share price was down due to the Eagle Ford sale for less than expected.

"There was also a sellsider downgrade."

On Monday, Hess Corp. sold some acres in the Eagle Ford shale in South Texas at a price that disappointed the market. The news was negative for Chesapeake, which has been trying to sell some assets in the same area.

On Tuesday, Sterne Agee downgraded the stock to underperform.

Hanson said that Chesapeake's stock price was volatile.

"Like most energy stocks, they tend to move a lot with oil and gas," he said.

"What I don't understand is how can you make the bet that the stock will trade in this narrow range. A stock like Chesapeake can move up and down much more than 8%.

"Your odds of getting it right are very slim. You have to get the commodity price right, and you have to get the stock valuation right. These two could diverge substantially."

The analyst is bullish on the stock with a $26.00 fair value estimate, or a 24% increase from Tuesday's price.

The notes priced on Thursday with an initial share price of $22.19, according to the filing. The threshold level, or 92.9% of the initial price, was $20.61.

According to Joe Bell, senior equity analyst at Schaeffer's Investment Research, the implied volatility on Thursday for the January 2014 contracts was 34.33%, or "more than double the S&P," which had an implied volatility of 14.32%. There are no March 2014 contracts available yet.

Gas glut

Another drawback for Zayed regarding the stock-linked notes was the company's vulnerability to weak natural gas prices.

"I don't like that the stock is directly tied to the price of natural gas, which is highly volatile. There's a glut of it with all that fracking, which naturally contributes to depress natural gas prices even more. I certainly wouldn't want to have exposure to that commodity," Zayed said.

Chesapeake is the second-largest producer of natural gas in the United States. Eighty percent of the company's sales last year came from natural gas.

"If you look at the 52-week range, from $13 to $26, you can see the stock can move a lot," he added.

"For me, the 8% coupon is not enough for the risk.

"You can get that easily with an index-based product, which would give you a better risk return.

"The coupon would have to be substantially higher, the buffer substantially bigger for me to even think of something linked to Chesapeake."

Cost of packaging

Jonathan Tiemann, president of Tiemann Investment Advisors, LLC, was wondering why the issuer picked Chesapeake as the underlying stock.

"You're selling an option that pays more premium because the underlying stock is volatile," he said.

"To have valuable optionality, you have to have volatility. It may very well be why they gravitated to this one.

"Or I can take a guess. It's a name Cramer talks about a lot. It may have something to do with it. That may be as much the reason as anything."

Tiemann said that by selling a call on the stock, one could get a higher return.

"It's a combination of the underlying and the short call," he said.

"Right now, I can sell a January 2014 call for 10% of the value of the stock."

However, he said that should the stock end negative, the 10% coupon equivalent (or premium) would be the only downside protection an investor may enjoy, whereas the noteholders could combine the 7% buffer with the 8% coupon for a protection of 15%, which is better.

But the call sale was one aspect, he said.

"Undoubtedly, you can construct a collection of options equivalent to this deal, but investors will have to pay the fee and the financing cost," he said.

"OK, there is some value to this packaging with the notes. The equivalent trade with options may have many legs and not everyone can do it. But who is interested in this packaging? It's got to be somebody so desperate for income because you have to be willing to tolerate the downside, the lack of liquidity and the cap. It's a big tradeoff.

"I can't get wildly enthusiastic about it."

Put sale

Philip Davis, founder of hedge fund Capital Ideas, said that if investors in the notes were willing to extend the trade by nine months, they would get better terms with a put sale.

He suggested that investors sell the January 2015 $18.00 put for $2.90. As a result, investors receive the $2.90 premium up front and are not forced to buy the stock as long as the price remains higher than the $18.00 strike price.

Because investors earn the $2.90 premium, their "break-even level" would be $15.10, or the difference between the strike and the premium.

"The $15.10 price is your real entry point if you buy the stock. So between that net level and the premium, you get a 19% return," he said.

He obtained the rate of return by dividing the premium by the true cost of the stock at $15.10.

On the downside, Davis evaluated the level of protection at 28%.

"The stock is currently trading at $21. All you need is for the stock not to drop below $18, so that's a stock that needs to hold 14% lower than what it is now. That 14% is your cushion to making the maximum profit. It's not even your cushion to protect you from first losses. Your first losses begin lower, at the break-even point, or $15.10. "That's the point below which you start to be hit with losses, not before, the equivalent of the buffer - and that's going to be the difference between the current price of $21.00 and your entry point of $15.10, or 28%," he said.

Looking at the notes, he said that investors are protected from up to 15% of losses on the downside, which is the combined buffer and coupon, while their maximum return is 8% on the upside.

"With this put sale, you get 28% on the downside and 19% as a rate of return. You have to go a little bit longer, but you can do much better," he said.

The agent for the notes (Cusip: 78011D781) was BofA Merrill Lynch.

The fee was 1.75%.

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