RBC's reverse convertible linked to ATP stands at risky end of product spectrum, analyst says

By Kenneth Lim

Boston, Sept. 10 - A planned reverse convertible note linked to a highly volatile stock offers a high level of risk for its potential returns, an analyst said.

Royal Bank of Canada plans to price 32% reverse convertibles due Dec. 20, 2010 linked to the common stock of ATP Oil & Gas Corp.

At maturity, investors will receive par unless the stock ends below its initial value and, during the life of the notes, has closed below 65% of its initial value. In that case, investors will receive a number of underlying shares equal to par divided by the initial stock price.

Pricing is expected on Wednesday.

Poor overall rating

The product was at the lower end of the spectrum for other recent products in terms of its overall rating, according to Future Value Consultants. The research firm gave the reverse convertible an overall rating of 3.01 out of a best possible 10.

"That's not a brilliant rating," said Future Value Consultants analyst Suzi Hampson.

The notes scored poorly on Future Value Consultants' assessment system partly because they did not rate well in terms of value and returns.

The notes received a return rating of 1.71 out of a best possible 10. Future Value Consultants' return rating reflects its opinion on the product's probable risk-adjusted return. The firm reckoned that holders of the product have an upside return expectation of 17.35% versus a downside return expectation of 62.19%.

The value rating, which expresses an estimate on how much investors are giving up in terms of fees and issuers' profit margins, also took a hit because of the short maturity of the notes. Hampson explained that shorter products tend to have lower value scores because investors essentially are amortizing the costs over a shorter period of time.

"Our value score favors slightly longer products," she said.

The value rating for these notes is 1.56 out of 10.

Large downside

The high 103.23% one-year historical volatility of the underlying stock also exposes holders of the product to considerable risk, Hampson said.

Based on the probability of incurring different levels of loss and the product volatility, Future Value Consultants assigned the notes a "riskmap" score of 7.8 out of a riskiest possible 10.

"The riskmap does look high," Hampson said.

Future Value Consultants estimated that investors have a 44.8% chance of losing more than 5% of their principal, versus a 54.1% chance of getting the principal back at par and making an annualized 32% from the coupon.

But investors will probably lose significantly more than 5% if they lose any capital at all because one loss condition is met only if the stock falls below 65% of its initial level.

"This is a three-month product, and the barrier is 65%, so we can probably assume that if the stock breaches the barrier at some point, because it's only a three-month term, there isn't much time to recover," Hampson said. "So you can probably assume that if you lose capital, you will lose a considerable amount."

Relative attraction

But the notes could still be attractive to investors who are willing to invest directly in ATP Oil & Gas' common stock, Hampson said.

From a risk perspective, the structured note offers some downside protection, and the product volatility of 53.03% is just over half of the stock's volatility.

Compared to a direct investment in the stock, the reverse convertible could outperform "under quite a few scenarios," Hampson said.

The barrier offers protection against up to a 35% decline in the stock, while the coupon reduces the total loss beyond that. Investors will also do better than the stock if it does not gain by more than 8% over the next three months.

"So it's only if the share grows beyond 8% that you would underperform," Hampson said. "And you've still got a return of 8% in three months."

Given the risky profile of the product, it is probably targeted at investors who want to invest directly in ATP Oil & Gas common stock, Hampson said.

"When we look at the riskiest end of products, they are aiming at people who are prepared to invest in the stock anyway," she said. "Yes, its riskmap is pretty high, but if it's someone who is going to invest in this stock, they already know the volatility."

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.