Worst-of convertibles not seen since 2008 due to losses, mispricing, increased correlation

By Emma Trincal

New York, Feb. 24 - Worst-of reverse convertible notes, a structure in favor before the credit crisis for its high coupons, has virtually vanished from the U.S. market, a New York sellsider said, predicting that those deals are unlikely to re-emerge anytime soon given the losses they generated.

"Banks are shying away from complex deals, they want something they can easily hedge," this sellsider said. "When you look back at the 2007-08 market, you had a lot of worst-of, which were risky products with a great deal of correlation. This market has imploded. You don't see them anymore. What you see instead are single-stock deals in traditional reverse convertible format or you see buffered, leveraged notes structured around indexes. Stock baskets are not in favor anymore."

The last deal

The last worst-of reverse convertible deal pricing in the United States occurred June 25, 2008, according to data compiled by Prospect News.

HSBC USA Inc. at the time priced a $678,000 "Dogs of the Dow" worst-of deal, with notes due Dec. 30 2008 linked to the 10 highest-yielding Dow Industrials stocks.

The year 2007 saw 19 worst-of deals totaling $38.14 million. In 2008, this number dropped to eight.

Reverse convertible variation

Similar to classic reverse convertibles, worst-of reverse convertibles appeal to investors for their very short duration and high coupon potential, said this sellsider.

Most deals have a maturity of three months or six months. One-year tenors are less frequent, according to Prospect News data.

The products operate similarly to reverse convertibles. Investors receive a steady stream of income. At maturity, they get either par or a predefined number of shares if the stock price falls below a barrier level.

One of the main differences is that worst-of deals have an underlying consisting of a basket of stocks or indexes rather than one security. The knock-in level is triggered by the worst-performing stock or index in the underlying basket.

HSBC was a very active issuer of worst-of products, according to the data. Other issuers included JPMorgan Chase & Co. in the United States as well as Barclays Bank plc, SG Structured Products, Inc. and Natixis in Europe.

Risk aversion

"We're seeing fewer worst-of deals. I would guess it's because those deals used to price when correlations were low," said Jakob Bronebakk, associate partner at Jubilee Financial Products, a structured products arranger.

"Past September 2008 with correlations increasing, those products became less attractive. It may be that the general risk aversion makes people less happy about it."

Mispriced correlation

For the New York sellsider, correlations between the underlying securities rose so quickly that worst-of structures became associated with risk. As a result, demand dried up in the United States.

"With correlation climbing so fast, trading desks were quickly unable to hedge their risk," he noted.

"Some trading books blew up because the deals were mispriced to begin with. You had a typical basket with a financial stock, an oil stock, retail and a technology company, for instance, something like JPMorgan, Schlumberger, Wal-Mart and Apple. When those deals were priced before 2008, traders made the mistake to bet that correlation would decrease. Instead it went up. By mid-2008, certainly early 2009, correlation rose to one and those products blew up because they had been mispriced and you didn't have enough cushion to hedge it," the sellsider said.

He noted that after September 2008, all markets and asset classes became "highly correlated" across the globe.

"Think of correlation sharply moving up in one day. It's impossible to hedge that. Traders took a hit. I don't think these structures are going to make a comeback anytime soon. People have been burned," the sellsider said.

A future offshore

Worst-of notes may not be registered in the United States, but the deals are still getting done, said Bronebakk.

"We're not seeing a lot of them, but there is demand though. If you look offshore, that's where the majority of the demand is. We're talking about deals for small, private banks," he said.

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