Barclays links reverse convertible to Deere; volatile underlying creates high risk, low value, analyst says

By Kenneth Lim

Boston, Jan. 23 - The extremely high underlying volatility of a planned Barclays Bank plc reverse convertible linked to Deere & Co. gives the product an unusually high risk profile and low value, said structured products analyst Suzi Hampson of Future Value Consultants.

Barclays plans to price a 15.3% reverse convertible due July 30, 2009 linked to the common stock of Deere.

At maturity, investors will receive par unless the underlying stock finishes below its initial level and closes below 60% of the initial level during the life of the notes. If both those conditions are met, investors will instead receive a number of Deere shares equal to the principal divided by the initial share price.

Future Value, which assesses structured products based on their value, simplicity, potential returns and risk, awarded the Barclays note 2.97 out of a best possible 10 in terms of overall rating. The product scored 7.4 out of 10 in terms of risk, where 10 is the riskiest.

"Reverse convertibles products would appeal to investors looking for interest above the risk free rate who can risk loss to their principal," the firm wrote in a research note. "The familiarity and reasonably simple structure of the product could offer further appeal to a less sophisticated investor."

In the research note, the firm noted that the product's potential upside return beyond the risk-free rates was 8.15%, compared to a potential downside loss beyond risk-free rates of 31.25%.

Volatile underlying

Compared to a direct investment in Deere stock, the product is relatively less risky, Hampson said.

"The introduction of the barrier makes the product less volatile, and the returns available to this prod are less volatile than the underlying because if you're just holding the underlying you're completely exposed to any drop in the underlying," she said.

But the product's poor scores are mostly a result of the extreme volatility of Deere shares, Hampson said.

"We've worked out that the underlying has got a volatility of 84.9%, which is obviously pretty significant, and the product's volatility is 38%, which is again pretty significant, which is higher than the S&P 500, and so at the moment, even including the barrier, it's more volatile than a direct holding in the S&P," Hampson said.

A portfolio with a 32.7% allocation to Deere stock, 50% allocation to bonds and 17.3% allocation to cash would give the same sensitivity to the underlying and interest rates at the start of the product, Future Value noted. Despite the high proportion of the hypothetical portfolio in bonds and cash, the volatility of the product remains high, Hampson explained.

"It's 32% investing in an 85% volatility underlying, which is still very risky," she said.

The 60% protection level would be quite generous in most products, but with an approximately 85% underlying volatility, that barrier is not worth as much in this note, Hampson said. And given the short tenor of the product, the risk is quite high of losing a significant amount of capital once the barrier is breached, she added.

"As soon as the barrier is broken the capital is at risk," she said. "If the product were to breach the barrier during the six-month period, the chance of the product going back above the initial level is quite low. If you lose capital, you're likely to lose a substantial amount of capital."

The 15.3% coupon, while "huge" in light of the current low interest rate environment, is also not high enough to give the product a better value score, Hampson said.

"In order to get a higher value rating, the issuers would have had to either increase the coupon or reduce the barrier," she said.

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