Barclays plans 10% reverse convertibles tied to Och-Ziff hedge fund, alternative asset manager

By Emma Trincal

New York, April 9 - Barclays Bank plc's upcoming reverse convertible notes linked to Och-Ziff Capital Management Group LLC shares may attract investors looking for more protection at the cost of a lower coupon and possibly seeking indirect exposure to alternative investments, said structured products analyst Suzi Hampson.

Relatively new underlying

Och-Ziff is a global hedge fund and alternative asset manager. Barclays priced a series of notes linked to this stock last month, a first since the company went public in 2007, according to data compiled by Prospect News.

So far, five deals linked to this stock have priced, all in a reverse convertible format and from Barclays.

The upcoming issue will carry a coupon of 10% and mature Oct. 29, 2010, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par in cash unless Och-Ziff shares fall below 75% of the initial price during the life of the notes and finish below the initial price, in which case the payout will be a number of Och-Ziff shares equal to $1,000 divided by the initial price.

Hedge fund entry

Hampson said that her firm, when analyzing underlyings, focuses on factors that drive pricing such as implied volatility and dividends rather than asset allocation and market views.

But looking at the stock of this particular company, Hampson said it was likely that the notes could be used as an asset allocation play in order to get indirect exposure to alternative investments via a stock.

"Investors often use reverse convertibles linked to a commodity stock as a way to access the commodity asset class. So I expect the same could be true with alternative investments since Och-Ziff is seen as an alternative investment stock," Hampson said.

Competitive pricing

Looking at the relationship between the implied volatility of the stock, the barrier and the coupon levels, Hampson concluded, "This note is competitively priced."

She said that for a reverse convertible, "the higher the volatility, generally the higher the coupon and the lower the barrier."

The stock has a 40.44% underlying volatility. Its implied volatility - a figure that the firm does not yet publish in its reports - is higher, said Hampson. "But it's not that much higher," she said.

"This stock does not strike me as being among the most volatile," she said.

Decent protection

"The 25% barrier represents a fairly decent level of protection for a six-month product. The issuer could have chosen a higher coupon. But they have gone for the more cautious option," she said.

Hampson noted that in prior offerings in which Barclays sold reverse convertibles linked to Och-Ziff shares, the bank used a variety of coupon and barrier combinations.

For instance, she said, this issuer priced a riskier version of this product last month with the sale of $2 million of 12% reverse convertible notes due Sept. 30, 2010 linked to Och-Ziff shares. The barrier was only 20%.

"You'll often see issuers selling the same underlying stock with the same maturity but with different terms, involving either a higher coupon with more risk or a lower coupon with less risk. That's because when they sell, they have to match the various levels of risk their clients are demanding," she said.

Risk not too bad

Riskmap - a Future Value Consultants rating that measures the risk associated with a product on a scale from zero to 10 - is 3.58 for this product.

"It's not too bad, and it represents a lower level of risk than some of the other products on the market," Hampson said, adding that the 25% barrier was the main risk-reducing factor.

The issuer's creditworthiness also drove the riskmap result, she said.

Five-year credit default swap spreads were earlier in the month 85 basis points for Barclays, she said, while the spread was 100 bps for Goldman Sachs and 150 bps for Citigroup.

The six-month maturity of the product also lowered risk, as the shorter the duration, the smaller the impact of credit risk on riskmap, she noted.

But a look at the chart illustrating the probabilities of product return outcomes (losses as well as gains) reveals that risk remains "considerable," she said.

Investors, according to the table published in the report, have a 28.4% chance of losing more than 5% of their principal.

On the other hand, their probability of maximizing returns is 70.1%.

"They have 70% chances of getting 10% a year, or 5% in six months, plus getting their principal back at maturity. That's the best possible outcome," she said.

"The way they do that is simply by not breaching the barrier since you get your coupon no matter what," she noted.

Low risk-adjusted return

Those probabilities derive from the same Monte Carlo simulation model Future Value Consultants is using to calculate its return rating, the risk-adjusted return of the notes on a scale of zero to 10.

For this deal, the return rating is 3.78.

"Return considers the risk-adjusted return, and I guess it is saying that for a product with a 28.4% chance of losing capital we would expect a higher cap on returns than 10% per annum," said Hampson.

It's equity

Because of the downside risk, Hampson said that this product should be viewed as equity rather than fixed-income.

"Investors considering this product should be stock investors," she said.

"When you have a 25% probability of losing capital, in my book, it's quite a lot. They have to be fairly risk happy. A bond is a completely different type of product," she said.

While a reverse convertible note "may perhaps be more conservative" than a stock due to "a little bit of protection," the product remains "fairly risky," as investors could lose their principal, she noted.

"Risk in these notes has to be compared to stocks," she said.

Less than average

The overall rating, on a scale of zero to 10, is 4.05. This rating is Future Value Consultants' opinion on the quality of a deal. It takes into account costs, structure and risk-return profile.

The simplicity rating, which measures the lack of complexity of a deal on a zero to 10 scale, is 8.50.

Value is another Future Value Consultants rating, which measures on the same scale how much money the issuer spent directly on the assets versus fees. This deal has a 2.09 value score.

The overall rating is an average of the three scores weighted 40% to the value score, 40% to the return score and 20% to the simplicity score.

"The overall is fairly low because both value rating and return rating have the same input to the overall score," said Hampson.

The notes are expected to price on April 27 and settle on April 30.

Barclays Capital Inc. is the agent.

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