With volatility up, skip reverse convertibles and think digital, says portfolio manager

By Emma Trincal

New York, Aug. 9 - The recent record gains in volatility offer a buying opportunity for investors looking for digital returns on the view that growth will be subdued or even flat, Eric Greschner, portfolio manager at Regatta Research & Money Management, told Prospect News.

"In order to take advantage of the market sell-off and the spike in implied volatilities, we struck two bespoke digitals on Thursday's and Friday's close," he said. He added a third deal on Tuesday.

Three deals

On Thursday, Greschner bought his first bespoke product: $1 million of 0% jump securities due Sept. 12, 2012 linked to the iShares MSCI Pacific ex-Japan index fund issued by Morgan Stanley.

The Dow Jones Industrial Average fell by more than 500 points on that day, and the VIX index rose 29% to nearly 32.

The structure is based on a final-day barrier, or European barrier, and does not necessitate any growth on the part of the underlying.

If the final Japan fund level is greater than the initial fund level, the payout at maturity will be par plus an 18% upside payment.

On Friday, Greschner bought his second deal: $750,000 of single review notes due Sept. 10, 2012 linked to the iShares MSCI Japan index fund issued by JPMorgan Chase & Co.

The custom-made offering gives his investors a premium of 11.25% under the same conditions - 0% growth or positive growth at maturity from the initial price. There is a 5% buffer on the downside with a 1% loss per point of decline beyond the buffer.

Finally on Tuesday, Greschner said he bought $564,000 of additional JPMorgan notes: non-buffered single review notes due Sept. 9, 2012 linked to the SPDR S&P 500 index fund.

If the final fund level is greater than or equal to the initial fund level, the notes will be automatically called at par plus a premium of 15.35%.

Not another reverse convertible

"A sell-off offers a great opportunity to buy structures that benefit from a spike in volatility," said Greschner.

"You can do that with reverse convertibles too. But we're not interested in reverse convertibles. One, because the underlying are not good quality. The names in the offerings tend to be stocks with a significant beta."

Another disadvantage of reverse convertibles, he said, compared to the notes he bought is that they are built around so-called American barriers, which can be triggered any time during the term and not just at maturity, an additional factor of risk.

"And the barrier levels themselves are really not attractive," he added.

Finally, reverse convertibles are linked to single stocks, while Greschner prefers to invest in broad sectors or geographic areas.

"It's so hard to find a good reverse convertible based on a broad, high-quality index of blue chip stocks," he said.

The three notes purchased by Greschner could in theory fall under the category of autocallables with one review date only. But Greschner disagrees.

"An autocallable most of the time has several call dates during the term. It means you don't know when and if you're going to get called. With these, you have a fixed maturity. That's a big difference," he said.

Short volatility

But the three types of structures have one thing in common: the investor gets a higher coupon as volatility goes up.

The investor in those notes is selling a put, he explained. As a result, the coupon payment increases with spikes in implied volatility because the premium rises when the risk of a price decline increases.

"An investor is a seller of volatility," he said.

"With the VIX ramping up to 50, we saw it as a huge opportunity to step in," said Greschner.

The VIX started last week at 23. It closed on Monday this week at 48.

"These deals do well with volatility spikes. This is reflected in the coupon, and we are definitely sellers of volatility right now. Our bet is that volatility will decrease."

Greschner said that he is not interested in notes with a payout linked to the appreciation of the underlying.

"We didn't want growth products. We have an outlook from low to mild growth," he said.

Knowing what he was looking for but unable to find it off-the-shelf, Greschner sought a customized deal.

"We came out with the idea. We bid it to four underwriters to find the most attractive product out there," he said.

"[Morgan Stanley and JPMorgan] did all the filing, the pricing, the hedging.

"Only our clients got this."

Buffer versus put

Among the three deals, only one offers some downside protection.

For Greschner, it was not necessarily a requirement as the strong sell-off has provided a floor to the equity markets at least for the one-year timeframe he chose for his investments.

In addition, Greschner said that Morgan Stanley offered its jump securities at price of 98.

"With the 18% coupon, it's an additional 2% for our clients. That's a 20% return. It's fairly substantial," he said.

Greschner is also bullish on Asian equity, at least in the short term.

"Emerging markets economies are fairly strong. Their only problem is inflation. There is the issue of interest rates hikes, but in 13 months, we will be OK. All we need is for things to stay positive," he said.

Finally, Greschner said that he hedges his notes using options and shorting various securities.

Marc Gerstein, research consultant at Portfolio 123 - who doesn't follow the Asian markets - said that the JPMorgan notes linked to the S&P 500 fund are attractive.

"It's not a bad deal. I like the structure. It's simple, easy to understand," he said.

"It's also nice to be able to get 15% even if the index doesn't do anything.

"The absence of a buffer may be a problem. If my upside is capped, I want a downside cap. But you can do it yourself, cutting a little bit of your upside by buying a put."

Gerstein said that he would also stay away from reverse convertibles at the moment.

"Volatility is so crazy ... a lot of those barriers are going to be breached," he said.

He agreed with Greschner that a final-day barrier is preferable to the American-style barriers built into reverse convertibles.

"When the performance is reviewed just once, at the end, it's different," he said. "In the meantime, you can go down and go back up.

"But with a reverse convertible, you hit the trigger and that's a done deal.

"I would look at a reverse convertible if I had a good feel for a stock and if I didn't mind owning it.

"Otherwise, volatility being what it is - and it's going to get worse because people don't realize how bad it is - I would stay away from them."

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.