With short-term reverse convertibles, investors must prioritize between barrier and coupon

By Emma Trincal

New York, Feb. 5 - When comparing two short-term reverse convertible notes, investors should look at the relationship between the barrier and the coupon. "A difference in barrier can have a significant impact on the coupon," said Suzi Hampson at Future Value Consultants. "A higher barrier can give you quite a jump on the coupon when you're dealing with very short-term paper."

Hampson compared two three-month reverse convertibles linked to the share price of the same stock offered by two different issuers.

High coupon, high barrier

JPMorgan Chase & Co. plans to price 15% annualized reverse convertibles due May 24, 2010 linked to the common stock of DryShips Inc., according to a FWP filing with the Securities and Exchange Commission.

Interest will be payable monthly.

The payout at maturity will be par unless DryShips stock falls below the barrier price - 75% of the initial share price - during the life of the notes and finishes below the initial share price, in which case the payout will be a number of DryShips shares equal to $1,000 divided by the initial share price or, at JPMorgan's option, the value of those shares in cash.

Coupon versus cushion

ABN Amro Bank NV priced $444,000 of 11% annualized Knock-in Reverse Exchangeable Securities due May 4, 2010 linked to the common stock of DryShips, according to a 424B2 filing with the SEC.

Interest is payable monthly.

The payout at maturity will be par unless DryShips stock falls by more than 30% during the life of the notes and finishes below the initial share price, in which case the payout will be a number of DryShips shares equal to $1,000 divided by the initial share price.

"The JPMorgan deal has a higher barrier, therefore more risk. But it pays 15%. On the other hand, the ABN Amro structure gives you more protection via the 70% barrier, but in return, you get a much lower coupon at 11%. Investors have to decide whether they want a higher level of risk associated with a higher coupon or less risk with a lower coupon," Hampson said.

Low Riskmap

Reviewing the JPMorgan structure first, which has yet to price, Hampson noted that the risk embedded in the notes is "fairly low" compared to many reverse convertibles.

Riskmap - a Future Value Consultants rating that measures the risk associated with a product on a scale of zero to 10 - is 2.65 for this product.

A glance at the probability table of return outcomes included in the firm's research report gives another read on the risk, she said.

With the JPMorgan reverse convertibles, investors have a 23% probability of losing more than 5% of their principal. While that probability is "somewhat high," other three-month convertibles can show "much higher" probabilities of losing more than 5% of par, Hampson said.

"The relatively low level of risk, as measured by Riskmap, is the combination of two things - a very short-term maturity and a barrier that is quite reasonable," Hampson said.

"The stock would have to drop by 25% in three months before the investor would lose any principal," she said in reference to the 75% barrier.

Midpoint volatility

The analysis of the annualized underlying volatility for this product - at 47.34% - is more of a mixed picture, Hampson said.

On the one hand, volatility is low enough to reduce risk, she observed. On the other hand, it is sufficiently high to give investors a better return than traditional fixed-income investments, she added.

Annualized volatility of the notes' underlying stock refers to the standard deviation of the price of the stock within a year timeframe. It is valued as a percentage of the mean.

"The higher the volatility, the more the stock price has moved," Hampson said. "And the higher the volatility, the greater the risk."

She said that at around 50%, this volatility level is relatively neutral compared to similar structures in the market. "We've seen higher volatilities for stocks of other reverse convertibles," she said.

"The risk for those notes is principally the result of the barrier level and the term, she said. "Volatility is a factor, but it's not the main factor of risk here," she noted.

On the other hand, the underlying volatility is high enough to give investors an attractive return, such as the 15% coupon, she noted.

"The underlying volatility is not the highest compared to other reverse convertibles," she said. "But it's high enough to allow you to fare better than a government bond that pays nothing."

Weak value

The overall rating of the notes is low at 3.39, said Hampson.

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

In this case, the main factor behind the low score is a 0.70 value rating.

The value rating on a scale of zero to 10 is Future Value Consultants' measure of how much money the issuer spent directly on the assets versus other transaction costs such as direct fees and profit margin on the underlying derivative

"The low value rating here is related to the duration. Because these notes are so short-term, certain fixed costs and fees may have lowered the score," said Hampson.

How big a loss

The overall rating is also affected by a low return rating of 3.44 on a scale of zero to 10. This rating is Future Value Consultants' indicator of the risk-adjusted return of the notes.

Hampson explained the coexistence of a low Riskmap and a low return rating.

"Return ratings do not just take into account the probability of losing capital. They also incorporate how much principal can be lost. If you breach the 75% barrier, you lose 25% in three months. Because it's such a short-term product, the size of the losses can be substantial on an annualized basis, and this certainly has an impact on the return ratings," Hampson said.

Different investments

Hampson compared the JPMorgan securities with the ABN Amro deal with a focus on the relationship between protection and coupon.

The ABN Amro structure has a lower Riskmap of 2.39 because of its more protective barrier of 70%, she said.

Similarly, the chances of losing more than 5% of par are 12.2% versus 23% with the other deal, a direct result of the added protection, she said.

"The trade-off is a much lower coupon of 11% instead of 15%," said Hampson.

"These are two very different investments. Obviously, the cost of additional protection is a lower coupon," she said.

Comparing the two structures in terms of their respective probabilities of losing more than 5% of par - a probability that's almost two times higher for the JPMorgan product that the ABN Amro deal - Hampson said, "That change of barrier has quite an impact on the probability of breaching it."

Hampson said that the ABN Amro reverse convertible "still offered well above market interest rates" and that, "for some investors, the reduced risk might still be worth it."

The JPMorgan notes are expected to price on Feb. 23 and settle on Feb. 26.

J.P. Morgan Securities Inc. is the agent.

The ABN Amro notes priced on Feb. 1 and settled on Feb. 4.

RBS Securities Inc. is the agent.

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