Financials-linked reverse convertibles see coupons dip as volatility declines, adviser says

By Kenneth Lim

Boston, Aug. 13 - Reverse convertibles linked to financials are coming with lower coupons because of falling underlying volatility, an investment adviser said.

Issuers on Thursday launched a couple of reverse convertibles linked to banking stocks.

JPMorgan Chase & Co. plans to price annualized 12.75% reverse convertibles due Aug. 31, 2010 linked to the stock of Bank of America Corp.

Investors at maturity will receive par if the stock ends above its initial level or never closes below the barrier at 60% of the initial share price. Otherwise investors will receive a number of Bank of America shares equal to par divided by the initial share price.

ABN Amro Bank NV plans to price annualized 17% reverse convertibles due Feb. 24, 2010 linked to the stock of Citigroup Inc.

The ABN Amro notes will have a barrier at 65% of the initial share price.

Lower coupons

JPMorgan in June also offered a one-year reverse convertible linked to Bank of America. But the older product had an annualized coupon of 19% and a barrier at 50% of the initial share price.

"They're definitely not offering as much as they were a few months ago," the adviser said. "The premium over risk-free isn't as high."

Falling implied volatility is pushing coupons lower and bringing barriers closer to initial stock prices, the adviser said.

"The financial sector stopped its freefall a few months back, and now people are talking about the end of the recession, so it's no surprise volatility and implied volatility have been falling," the adviser said. "When volatility is lower, you get less for the put option that you're selling to the issuer."

But the comparison to products issued over the past year may not be as meaningful as investors might think, the adviser said.

"You're talking about coming down from historically high volatility," the adviser said. "The kind of coupons we were getting a few months ago, are not the kind of coupon we would normally get on this particular sector."

Still useful

Reverse convertibles will continue to be useful investments even if volatility declines, the adviser said. First of all, lower volatility usually comes with an increase in the comfort level of investors.

"The reverse convertible is a bullish product, so investors are actually more attracted to the reverse convertible when volatility is falling," the adviser said.

"You have a lower risk of breaching the barrier and a higher probability of enjoying a high yield and potentially outperforming the underlying asset. There's a reason people stopped buying equity-linked products when equity volatility shot through the roof."

Investors who are moderately bullish about financial stocks can still find interesting short-term options in the structured products wrapper, the adviser added.

"The reasons why the reverse convertible can be attractive when volatility is higher are the same when volatility is lower," the adviser said. "High income-generating investment, potential outperformance of the underlying both on the upside and on the downside. The numbers themselves may look different, but relative to current market conditions, it's often the same effect."

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