Comparing reverse convertibles with slightly different coupons: details matter, analyst says

By Emma Trincal

New York, Dec. 11 - Investors should be careful when selecting between various reverse convertible issues as slight differences in coupons between products having similar structures and underlying are often the basis for key decision, said Suzi Hampson, structured products analyst at Future Value Consultants.

"There are so many reverse convertibles that get issued; these little details are all over the place. As an investor or an adviser, you have to weigh these things up. You have to assume that deals are quite competitively priced and so these slight differences do add up," said Hampson.

Hampson compared three different reverse convertible deals from three different issuers, all of which linked to the same underlying - the common stock of MetLife, Inc.

Two of the structures had comparable terms - six months - but different barriers.

The third deal had a longer maturity than the two others - it was a one-year maturity - but sharing the same barrier as one of the two other deals.

Same barrier deals

Hampson began her comparison between the one-year and the six-month deals, both of which had the same 70% barrier. She said that she was "surprised to see that the one-year term had a lower coupon," adding that "intuitively, you would expect the opposite since they have exactly the same barrier and underlying."

The one-year product comes from Barclays Bank plc. This issuer plans to price 12.25% reverse convertible notes due Dec. 30, 2010 linked to MetLife.

The payout at maturity will be par in cash unless MetLife shares fall below the protection price - 70% of the initial share price - during the life of the notes and finish below the initial price, in which case the payout will be a number of shares of MetLife stock equal to $1,000 divided by the initial share price.

The six-month product with the exact same 70% barrier was announced by ABN Amro Bank NV. The notes due June 30, 2010 linked to the same stock offered in the original filing have a 13.75% coupon. Recently, the issuer announced that it had lowered the coupon to 13.25%, according to an FWP filing with the Securities and Exchange Commission.

Nevertheless, the 13.25% coupon for ABN Amro's six-month deal remains higher than Barclays' 12.25%, even though the Barclays notes are twice longer in duration, noted Hampson.

"If you think of reverse convertible as a structure that offers you more in proportion to how much capital you're putting at risk, then the lower coupon on the Barclays notes is difficult to explain intuitively since you have the same underlying stock and the same amount of downside protection," said Hampson.

But Hampson said that there is an explanation from the point of view of the structurer, which she summarized in those terms: "the cost of options is not linear."

She explained that for the pricing of reverse convertibles, the issuer builds its hedge by selling put options on the underlying stock.

"You would think a one-year put would represent twice the cost of a six-month put," she said. "But it doesn't really work that way."

She said using a hypothetical example that if for instance a one-year put had a cost of 100, the six-month option could very well cost 60 or 70 rather than 50.

Two similar maturities

Eksportfinans ASA was the third deal examined by Hampson. This issuer said it plans to price enhanced yield securities due July 1, 2010 linked to MetLife stock via underwriter Wells Fargo Securities, LLC, according to an FWP filing with the SEC.

The notes will carry an annualized coupon of 13% to 14%, with the exact coupon to be set at pricing.

The payout at maturity will be par unless MetLife stock falls by 25% or more during the life of the notes and finishes below the initial share price, in which case investors will receive a number of MetLife shares equal to $1,000 divided by the initial share price.

Hampson assumed that the coupon would be set at 13.50%, midpoint in the range. She proceeded to compare this deal with the ABN Amro notes as both have the same six-month tenor.

Competitive pricing

Hampson conducted her analysis prior to knowing about the repricing of the ABN Amro deal.

At that point the ABN Amro notes had a 13.75% coupon with a 70% barrier. It compared with the Eksportfinans' presumed 13.50% coupon featuring a 75% barrier.

Hampson said that Eksportfinans carried the lowest and riskiest barrier, leaving more risk to the investors in its notes. As a result, Eksportfinans should have been able to offer a coupon higher than that of ABN Amro, which was not the case, noted Hampson.

"If Eksportfinans prices at 13.50%, then its product would be worse for the investor [than the ABN Amro notes]," she said. "It may influence pricing."

Whether issuers adjust to the competition by increasing or lowering their coupons depends on the situations, she noted. Hampson predicted that Eksportfinans may have to raise its coupon toward the 14% higher range. As it turned out, ABN Amro has already decided to lower its coupon by 50 basis points.

The market is displaying "competitively priced" deals, said Hampson.

"If you sell anything, whether beans or structured products, you look around and see what your competition is pricing," said Hampson.

Credit risk factor

Another element that explains the slight coupon differences between relatively similar deals offered by different issuers, said Hampson, citing credit risk.

Eksportfinans is rated AA by Standard & Poor's, and ABN Amro carries an A+ rating, noted Hampson.

She said that an issuer with a lower barrier but better credit may be able to offer a lower coupon, as investors pay attention to the issuer's credit when making their investment decisions.

"These are two six-month notes, so the issuer's credit is less important. However, it's still significant because in six months, things could happen. As a result, you don't want to write off this aspect of your investment decision," she said.

Analysis versus ratings

The analysis is rendered more difficult because all three deals carry "very similar" ratings based on Future Value Consultants' research methodology.

Their overall rating, which on a scale of zero to 10, measures the quality of a deal, taking into account costs, structure and risk-return profile are almost identical, Hampson said. The Barclays deal has a 5.94 overall rating versus 6.01 and 6.07 for Eksportfinans and ABN Amro, respectively.

Their respective risks, as measured on a scale from zero to one by riskmap, the firm's indicator, are also very much alike, she noted. Barclays' carries a riskmap of 8.14. Eksportfinans has an 8.26 riskmap versus 8.21 for ABN Amro.

"These results are not surprising because those deals have all the same underlying and they are similarly priced with the same ballpark risk," said Hampson.

"It makes it all the more challenging for investors and their advisers to identify the key details of each structure. But it can be done because there are not that many moving parts in a reverse convertible: You are basically trading risk for coupon."

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