Merrill floaters 'well-crafted', analyst says; JPMorgan's Walt Disney reverse convertibles attractive

By Kenneth Lim

Boston, March 7 - Merrill Lynch & Co. Inc.'s floating-rate notes due March 2009 linked to the S&P Diversified Trends Indicator Price Return Index is a potentially attractive but highly risky offering, said Future Value Consultants analyst Tim Mortimer.

The notes will pay interest quarterly, with the rate set at 3-month Libor minus a spread of 12 basis points. Upon maturity, the notes will pay par of $10,000 plus three times the index return less an annual fee of 1.6% per year if the index ends higher. If the index ends lower, the notes will pay par minus three times the index return less the annual fee.

The notes will be redeemed early if the index level closes below 85% of the starting value of the index, with the payout calculated the same way as redemption at maturity.

There is no principal protection.

The S&P Diversified Trends Indicator Price Return Index tracks the value of 24 commodities by reference to eight financial sector futures and six commodity sector futures. The financial and commodity sectors are equally weighted in the index. Each sector is represented on either a long or short basis, depending on recent price trends in the sector.

A Standard & Poor's representative explained that the indicator is not meant to mirror short-term changes in the prices of the underlying assets. Instead, it aims to reflect the long-term trend of those prices and, because of the low correlations between its components, is designed to have relatively low volatility.

Future Value's Mortimer said the product appeared to be "a well-crafted strategy."

"It's a more sophisticated product," he said. "The underlying is probably something that's harder to access."

Mortimer said the inclusion of a coupon plus the accelerated return of the underlying offer an attractive upside.

"The actual profile I quite like because of the commodities and currencies...It's got quite a flat forward instead of an equity index, which allows me to get 12 basis points off Libor on top of this metric," he said. "Even if the index were actually flat, you could end up with a Libor minus 12 bps return. So I guess it's comparable to a BBB note or something like that."

Mortimer noted the high risk involved in the note, which exposes the investor to three times any decline in the underlying index. The auto-redemption option is therefore a critical aspect of the structure, offering a stop-loss mechanism even though a significant portion of the principal would have been wiped out by the time the redemption occurs.

"The call option is quite significant," Mortimer said. "Once the index falls 33% from where it is now, the capital could be 0. So 33% is not impossible by any chance. So if it's 85%, by which time you've already lost 45% of your principal, certainly the call will be very important."

"The game is over fairly quickly if the index falls by 15%," he added.

Underlyings affect risk

An analysis of three similar Accelerated Return Equity Securities (ARES) by Credit Suisse Nassau Branch reflect how the volatility of the underlying indexes can affect the risk of the structured products, Mortimer said.

Credit Suisse is offering the 0% notes due April 30, 2009.

If the underlying index ends above its initial level, the payout at maturity for all three series will be par plus four times the index increase, subject to caps that will be determined at pricing. If the underlying index ends below the initial level, investors will lose 1% of the principal for every 1% decline in the index. There is no principal protection.

The cap for the notes linked to the Dow Jones Euro Stoxx 50 Index and the notes linked to the Nikkei 225 Index will be between 17.25% and 19.25%, or an increase of 4.31% to 4.81% in the underlying. The cap for the notes linked to the S&P 500 Index will be between 15.5% and 17.5%, or an increase of 3.88% to 4.38%.

Despite similar structures, the S&P-linked product appears less risky than the other two because of the nature of the underlying, Mortimer said.

"The S&P has got a significantly lower risk rating, but the cap is lower," he said. "It's less risky because the volatility of the S&P is rather lower than the other two."

Although the Euro Stoxx and Nikkei products appear very risky compared to other similar products launched recently, Mortimer said they nevertheless were comparable to similar investments made through mutual funds.

"The risk maps are quite high for the Euro Stoxx and the Nikkei," he said. "It's quite risky compared to other structured products, but in the risk analysis you could put a mutual fund in there and if you do that...it's quite illuminating. It's a risk level comparable to a pretty standard mutual fund. It just looks risky compared to other structured products. It only needs a very small rise in the Nikkei to get the full return."

JPMorgan-Disney notes attractive

Mortimer highlighted JPMorgan Chase & Co.'s 8.25% reverse convertible due March 31, 2009 linked to the common stock of Walt Disney Co. as a reverse product with an attractive risk profile.

"The risk is kept quite low," Mortimer said. "The interest is lower than most other reverse convertibles, but it's less risky."

The notes will return the number of shares equal to par of $1,000 divided by the initial underlying share price if the underlying has fallen below the barrier level of 80% of the initial share price and ends below the initial share price. Otherwise the notes will pay par at maturity.

Mortimer said most other reverse convertibles have higher coupons but weaker principal protection, but in this case the trade-off works. Getting an 8.25% coupon on an underlying like Walt Disney stock is attractive, he said.

"Personally I think prefer this rather than those that are riskier and offer a much higher interest," he said.

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