Issuers link fewer products to Financial Select SPDR, accelerated structures out of favor, analyst says

By Kenneth Lim

Boston, April 3 - Issuers are offering fewer products linked to the Financial Select Sector SPDR fund so far this year, and those that use the fund are not as focused on growth, said structured products analyst Suzi Hampson of Future Value Consultants.

"This is quite a volatile underlying now, much more so than it was last summer," she said. "Back then you saw a lot of accelerated growth products, more so than reverse convertibles, as I remember. But now you're seeing more reverse convertibles, because I think there's less emphasis on the underlying growing."

Reverse convertibles tend to have lower barriers than the buffers in accelerated products, so some investors could feel more comfortable buying reverse convertibles, Hampson said.

"The underlying indices just have to stay above the barrier in order to pay the principal, so with a highly volatile underlying that might be more appealing to investors," she said. "A 10% buffer is much less protection, and the variance in the potential return is higher."

Not for recovery

The reverse convertible structure is not designed for investors who expect a recovery in the underlying, Hampson added.

"In a reverse convertible all the underlying has to do is not fall below 50%, for example," she said. "It's not exactly taking a confident view of the underlying. And investors looking for recovery products will be looking more for growth products in particular, like accelerated growth products...or kickout review products."

A reverse convertible would be attractive to investors who thought that the underlying would become less volatile, Hampson said.

"It's an investor who thinks the implied volatility of this underlying is higher than what it's going to be in the next half year or so," she said. "And investors who don't think the fund is going to fall by half. That's quite a substantial amount. And someone who wants the coupon...Someone not necessarily taking a promising view of the fund, just the opinion that it's not going to fall by half."

Tricky barriers

Morgan Stanley is revisiting that exchange-traded fund with a planned offering of 11% to 15% reverse convertibles due Oct. 15, 2009 linked to the Financial Select Sector SPDR. The exact annualized coupon, which will be paid monthly, will be set at pricing.

At maturity, investors will receive par unless the underlying fund finishes below its initial level and has closed below 50% of its initial level during the life of the notes. Otherwise investors will receive a number of shares of the underlying fund equal to par divided by the initial price.

The barrier appears generous, but investors should be aware of the high underlying volatility, Hampson said.

"I think it would be appeal to investors...the barrier does appear at first glance to be quite low, but it's only made possible by the high volatility in the underlying," she said.

The historical volatility of the Financial Select Sector SPDR is about 71%, which suggests that hitting the barrier is not that remote a possibility, she said.

"The likelihood of hitting the barrier is quite high, and if it hits the barrier the likelihood of losing a lot of capital is quite high," Hampson said.

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