Investors in reverse convertibles should understand stocks, have a view, analyst says

By Emma Trincal

New York, Dec. 18 - Investors seeking high income when purchasing reverse convertibles should have a view on the underlying stock as those investments carry risk, said structured products consultant Suzi Hampson of Future Value Consultants.

"The high coupons offered by reverse convertibles linked to a stock are appealing for people looking for income. And you do get a guaranteed coupon no matter what. But it comes with downside risk. As an investor, you have to be risk happy and used to invest in stocks," Hampson said.

Hampson compared two announced reverse convertible deals her firm analyzed in two different reports. Both had the same issuer and an identical three-month term. Each deal was tied to the price of a bank stock.

The first deal was Royal Bank of Canada's planned 15.25% reverse convertible notes due March 31, 2010 linked to Citigroup Inc.

The payout at maturity will be par in cash unless Citigroup shares fall below 80% of the initial price during the life of the notes and finish below the initial price, in which case the payout will be a number of Citigroup shares equal to $1,000 divided by the initial price.

The notes are expected to price on Dec. 23 and settle on Dec. 31.

In the second example, Royal Bank of Canada announced plans to price 18.5% reverse convertible notes due March 31, 2010 linked to KeyCorp shares.

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

The notes are expected to price on Dec. 23 and settle on Dec. 31.

Risk and annualized volatility

Hampson said that both deals are "fairly risky," which, she said, is due to the historical or annualized volatility of their respective underlying stocks.

Annualized volatility for KeyCorp was 68.58%. It was 67.66% for Citigroup.

Hampson said that an underlying with an annualized volatility in excess of 60% often suggest riskier structures, as a great number of reverse convertibles tend to show volatility in the 50% to 60% range.

The historical volatility, she said, will influence how Future Value Consultants scores the return and riskmap ratings that are part of the research firm's methodology.

Pricing on the other hand is determined at the end and reflects the implied volatility, she said. "Implied volatility takes into account where the market thinks the stock price will be in the future," she said.

Pricing and implied volatility

Recent negative headlines around Citigroup pushed down its stock price last week - the government balked at selling its 34% stake in the bank due to the exceptionally low price of the stock, which caused the share prices to tumble further. But the filing date preceded those events, Hampson noted.

"With what's happening now, strong moves in implied volatility would not be surprising, in which case it might impact pricing," she said.

"We see products that don't make it to the final stage, and it's not always easy to know why," she said, adding that "we don't spend a lot of time looking at final terms although we update our reports on the day following the pricing."

One beats the other

Comparing the two products, Hampson noted that the reverse convertible linked to KeyCorp offered "better terms" than the notes linked to Citigroup.

"I have to assume that KeyCorp has a higher implied volatility because the notes associated with this underlying offer both a higher coupon and a lower barrier. And those two components - the coupon and the barrier - are linked to the implied volatility," she said. "If both stocks had the same implied volatility, then you would expect that the one with the higher coupon would also have the lower barrier. But it's not the case here," she said.

The deal linked to KeyCorp also showed a better overall rating than the other, 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.

The Citigroup structure had a 4.15 overall rating while the score was 5.64 for the reverse convertibles linked to KeyCorp's stock price.

Added value

Among the three factors used to aggregate this rating, value is one of the most important with a 40% weight, Hampson said. The value rating for the Citigroup notes was 4.54 compared to 7.89 for the KeyCorp deal. This rating, on a scale of zero to 10, is how Future Value Consultants measures how much money the issuer spent directly purchasing the assets versus other transaction costs such as direct fees and profit margins.

"This shows that we think Royal Bank of Canada spent more when buying the assets on the KeyCorp deal than on the Citigroup deal. You get more value for your money," Hampson said, adding that this factor was the main reason why the overall rating was higher.

Both risky

Hampson then looked at the risk associated with both deals as measured by Riskmap, her firm's rating that measures risk on a scale of zero to 10.

Riskmap was higher for the Citigroup structure with a 6.64 score versus 5.11 for the KeyCorp deal.

"This is simply due to the 75% barrier versus 80%," Hampson said.

Hampson however noted that overall both products were "fairly risky" given the relatively high annualized volatility of their respective underlying stocks.

"These are at the top end of risk as far as the products we look at," she noted.

More risk will affect the return ratings computed by Future Value Consultants, which on a scale of one to 10 measures the risk-adjusted return of the notes.

Because the risks associated with both products are high, the return ratings are "quite low," said Hampson.

The return ratings of the Citigroup and KeyCorp deals were 1.58 and 1.97 respectively.

"With both products, you have a high probability of losing capital," Hampson said.

Pointing to the probability tables published in her reports, Hampson said that "investors in the Citigroup notes have 42.6% chances of losing more than 5% of their principal and a 38.4% probability with the other deal."

Stock savvy

In conclusion, Hampson said that "We looked at both products. Both are at the riskier end of the scale and the probabilities of losses are still very high. But investors are entitled to get very high coupons at the end of a short-term period, which makes those products attractive to them."

Hampson said that investors trying to choose between different reverse convertibles "should know about the stock."

"Having a view, especially, being able to make assumptions on a stock's implied volatility is more important with a reverse convertible than with any other products," she said.

Hampson added that investors should look for stocks whose implied volatility is expected to decline during the term. "This way, your stock won't move too much and you won't hit the barrier, so you can earn the high coupon without losing your principal," she said.

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