Reverse convertibles attractive in nervous market, analyst says; Dogs of Dow products not that different

By Kenneth Lim

Boston, April 11 - Reverse convertibles could be more attractive to investors now amid widespread uncertainty in the market, structured products analyst Tim Mortimer of Future Value Consultants said.

"If you believe that both volatility levels and options prices are somewhat inflated because of nervousness, investors on a forward-looking basis should perhaps think about these reverse convertible strategies," Mortimer said.

In the wake of the subprime crisis and the bailout of Bear Stearns, volatility and credit spreads have climbed to recent highs. The rapid expansion of volatility and spreads has shifted the pricing of structured products in favor of investors, he said.

"Because of the whole credit spread concerns and the whole funding issue, a number of issuers have quite high credit spreads now, and it improves the headline terms they can give investors," Mortimer said.

Investors today could take the view that some of the uncertainty may be overdone and buy into strategies to exploit that perspective.

"Whether it's the bottom, nobody knows, but the volatility levels are very high compared to those historically, and it's hard to make a case that it will continue for long," Mortimer said. "The timing is probably a good one for reverse convertibles."

Regardless of where volatility and credit spreads are heading, the generous terms that reverse convertibles are coming on are a good reason to take a closer look, he said.

"It's always a bit dangerous to think that market pricing levels are wrong, but given that stocks are down and the volatility levels are already high...the volatility levels give you a healthy coupon," he said.

"You really want something where the coupon that's being earned is higher than the risk. As long as you're being compensated more than the risk and you are happy with the risk level, it's a sound investment," he added.

Dogs not so different

Two recent reverse convertibles linked to the worst performer in baskets of Dogs of the Dow stocks were examples of the generous coupons that issuers can now offer.

HSBC USA Inc.'s 25% reverse convertible due Oct. 30, 2008 is linked to the worst performer of the 10 Dogs of the Dow stocks as of March 2008. The stocks, which are the Dow Jones Industrial Average component stocks with the highest dividend yield, are AT&T Inc., Bank of America Corp., Citigroup Inc., E.I. du Pont de Nemours & Co., General Electric Co., General Motors Corp., JPMorgan Chase & Co., Merck & Co. Inc., Pfizer Inc. and Verizon Communications Inc.

Fortis Bank, Cayman Islands Branch, through JVB Financial, is also issuing 25.5% reverse convertibles due Oct 30, 2008 linked to the worst performer of five Dogs of the Dow stocks as of March 2008. Its underlying stocks are Citigroup, General Motors, Merck, Pfizer and Verizon.

Both series have the same barrier at 50% of the initial share price. If any of the underlying stocks fall below the barrier during the life of the notes and any of the underlying stocks finishes below its initial level, the payout will be the number of shares of the worst performing stock divided by its initial share price. Otherwise the payout will be par.

"It's an interesting comparison because the JVB has got a 25.5% coupon, the HSBC is 25%," Mortimer said. "It's the same maturity, but JVB has linked to five stocks, HSBC has got all 10, so it's got that five and another five, and you've got the worst performer for both products. At first glance, the JVB product would be better because it's got a higher coupon and it's only linked to five."

But investors of the Fortis product are taking on a higher risk of issuer default than investors of the HSBC product, Mortimer said.

"It would appear that HSBC's credit in the market is stronger than Fortis, although over a six month period it doesn't make much of a difference," he said. "You're taking credit risk over six months, which is not the same as taking credit risk for five years, for example."

Investors will therefore have to choose between taking a note with a slightly better coupon versus a note with a slightly better credit, he said.

"On balance, the question is which is more important," Mortimer said.

The difference in the number of underlying stocks - linking to the worst performer of five stocks is riskier than linking to the worst performer of those five stocks plus another five - is also not that big, he said.

"In terms of the pricing, General Motors is probably the most volatile of the stocks there, and that's in both collections of stocks," he explained. "Because of the way the options are priced, although adding in another five may seem a bit scary, in fact the most volatile one, General Motors, is in there in both, so adding another five, although it's more risky, it's not as much as you might assume."

There is also a possibility that all the Dogs of the Dow will move in tandem if the market takes another hit, which would make it less significant whether one product is linked to five or 10 Dogs.

"For either product to be trouble, you need to have one of the stocks break the barrier. But there's usually a very high correlation under a crash situation, so when something happens everything tends to nosedive together," Mortimer said. "So from that logic you can see that adding in five more doesn't make that much more difference. There's still more risk from an equity point of view, but not as much as you might expect."

Despite the attractiveness of the coupon and the reverse convertible strategy, Mortimer advised caution.

"This usage of the Dogs of the Dow in particular is quite interesting," he said. "Everyone knows what's in the Dow, firstly. It's been a benchmark index for decades...but there's obviously a world of difference between linking to the Dow and the worst of the Dogs of the Dow. For example, you have Citigroup in there. A Dogs of the Dow product that was issued last year would probably have had a barrier event."

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