Barclays' 15%-17% reverse convertibles linked to Best Buy show high risk despite low barrier

By Emma Trincal

New York, July 27 - Barclays Bank plc's 15% to 17% reverse convertible notes due Feb. 7, 2013 linked to Best Buy Co., Inc. shares offer an attractive barrier, but compensation for the risk may not be enough given the high volatility of the underlying stock, said Gurdeep Ubhi, structured products analyst at Future Value Consultants.

The product offers an eye-catching barrier of 60% of the initial price on just a six-month maturity, he said.

But investors need to give the product a closer look, he added.

The payout at maturity will be par in cash unless Best Buy shares fall below 60% of the initial price during the life of the notes and close below the initial price at maturity, in which case the payout will be a number of Best Buy shares equal to $1,000 divided by the initial price, according to an FWP filing with the Securities and Exchange Commission.

The exact coupon will be set at pricing.

On the surface

"It looks good on the surface. The 60% barrier compares well with similar products of the same maturity," Ubhi said.

"The stock however is very volatile. Although the barrier is deep, there is a considerable risk of breaching it.

"Investors should not focus excessively on the terms when picking a reverse convertible. It's not just about the high coupon or the deep barrier. First, they have to look at the underlying stock because that's what your performance return depends on, especially for products at risk."

By that, he meant the volatility of the stock since investors in reverse convertibles are paid a fixed coupon. They only lose return and/or principal when the stock finishes down and breaks the downside barrier.

The one-year implied volatility of Best Buy stock is 55%, he said, in comparison to about 20% for the S&P 500.

"Obviously there's a reason why you have such a low barrier and why the scores are below average," he said, commenting on the various scores assigned to the product by Future Value Consultants.

"You can't really compare it with the S&P 500. But you can compare it with another common stock used in other reverse convertibles. Take Apple for instance: it has a one-year implied volatility of 24%. That's a huge difference.

"This note is for someone willing to accept the risk that comes from the high volatility of the underlying. It's for someone who wants to take a position in the stock but wants to have protection.

"Both the barrier and the coupon in place help reduce the exposure to volatility."

High risk

The ratings on the products reflect the high risk caused by the volatility level, which, he added, has been rising since the beginning of the year.

Future Value Consultants measures the risk with its riskmap on a scale of zero to 10, with 10 being the highest score for risk. The riskmap is the sum of two risk components: market risk and credit risk.

The notes show a higher riskmap than comparable products, he said. Its score is 6.11 versus 4.33 for the average reverse convertible.

"It comes mostly from the market risk, which is higher than the average for that product type," he said.

The market risk is 5.51, compared with 3.77 for the average reverse convertible.

The high market risk again is a direct result of the volatility level.

Despite the 40% of contingent protection, the probability of the stock breaking through the barrier remains high, he explained.

On the other hand, the credit riskmap at 0.60 is in line with the average of 0.56.

"Most of the risk comes from the volatility of the asset. It all boils down to market risk," he said.

Return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios. In this case, the best scenario would be low volatility.

In a neutral scenario, the probability table shows a 20% chance of incurring a principal loss of 15% or more against an 80% probability of generating a return of more than 15%.

"One chance out of five that the barrier will be breached: that's a lot," he said.

"And when you go down 40%, the odds of finishing up above the initial price are quite slim."

The return score at 5.65 is also lower than the 6.10 average.

"For a product that contains that amount of risk, they should be offering a higher coupon. The 15% to 17% coupon is not a huge amount when you have that type of volatility," he said.

Price, overall

The relatively low price score is driven by the same logic, he said.

The price score on a scale of zero to 10 gives an estimate of the value offered to investors. The higher the score, the lower the fees and the greater the amount spent on the options to add value for the investor.

Compared to an average price score of 6.62 for reverse convertibles, this product has a 5.82 price score.

"The premium they paid for the short put should be higher. It looks like they need to spend more to make the product more balanced," he said.

"The higher the volatility, the greater the risk and therefore, the more premium you should get for taking the risk of the put being exercised."

Future Value Consultants gives its opinion on the quality of a deal with its overall score, which is based on the average of the price score and the return score.

The notes' overall score of 5.73 is below the 6.36 average.

"This is for a short-term investor who wants exposure to this stock and some protection against the volatility," he said.

"But despite an apparently attractive barrier, the risk/return is below average as well as the price score.

"What is missing is a higher coupon. In order to add value to the investors and to provide them with an adequate compensation for the risk, the coupon should be higher."

The notes are expected to price Thursday and settle Aug. 7.

Barclays Capital Inc. is the agent.

The Cusip number is 06741JK73.

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