Financials-linked reverse convertibles pricing more attractively as volatility spikes, analyst says

By Kenneth Lim

Boston, July 25 - The recent spike in volatility in the financial sector has allowed issuers to price products with more attractive terms, said Future Value Consultants analyst Suzi Hampson.

"It looks like much better terms, but the volatility has gone up and the terms are a reflection of that," Hampson said.

Financials volatility climbed

Volatility in the financial sector has been high all year, but the risk metric went even higher the past few weeks, Hampson said.

That has led to markedly different pricing in recent products linked to the sector compared to similar products earlier in the year, she said. The change in volatility has also affected investors' assessments of products, she said.

"It has a big effect on pricing," Hampson said. "As far as our scores go, volatility is an important component, it's a big part of it. Other things that could be in there are interest rates, the dividend yield of the stock, but volatility has a big effect especially on the capital-at-risk products."

Terms changing with volatility

Hampson highlighted reverse convertibles linked to the common stock of Bank of America Corp. as an example of how pricing has changed.

In May, Barclays Bank plc priced a series of 9.7% reverse convertibles due Nov. 20, 2008 linked to the Bank of America common stock. The notes had a protection level of 70%, meaning that investors will receive par at maturity if the underlying stock ends at or above its initial level and never closes below the protection level during the life of the notes. If both those conditions are met, investors will receive the number of shares equal to par divided by the initial share price or the cash equivalent.

The volatility of Bank of America back then was around 29% to 30%, Hampson said.

In early July, when Bank of America's stock volatility had climbed to between the high-40% region and 50%, Barclays launched another series of reverse convertibles linked to Bank of America.

The newer notes, which will price July 28, have a coupon of 15% and a protection level of 60%.

"You can see the effect that volatility had on the product," Hampson said. "The one in May, when the stock had a lower volatility, you see a lower coupon and a higher barrier, whereas now...the volatility has increased, and the coupon has gone up and the barrier has gone down."

The trend is true among most names in the financial sector, she said.

"All of this year, really, we've seen quite a lot of volatility in the sector," Hampson said.

Impact varies with product

The effect that the different pricing has had on the attractiveness of the notes is not uniform, Hampson said.

Reverse convertibles, accelerated growth notes and capital-at-risk products are likely to be priced with terms that look more enticing when volatility goes up, she said.

But with principal-protected notes, "the terms look less attractive because the options become more expensive," she said.

Within the same structure, a change in volatility also does not always lead to the same differences in the products' appeal.

"As long as the terms are fair, if you have the same terms, if the volatility goes up and the terms stay the same, then it's going to score worse," Hampson said. "But the scores will depend on how they priced at the time. Just because it's a more volatile stock doesn't mean it's going to get a worse score...if they used the volatility to get a lower barrier and a higher coupon, there's no reason why it shouldn't score higher."

She again used the two Barclays notes as an example. Future Value scores structured products using its assessment of each product's value, return, simplicity and risk. The earlier note, which had a higher volatility, was actually assessed as less risky than the later note, Hampson said.

"The higher the coupon, the more volatile the stock, and that has to be taken into account," she said. "The risk is lower on the higher coupon product, so in our analysis the higher coupon one comes off better, but for the value ratings, the lower coupon ones are better."

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