UBS' $30.45 million 9.9% notes tied to Dow Chemical attract yield seekers, moderate bulls

By Emma Trincal

New York, April 26 - UBS AG, London Branch's $30.45 million sale of 9.9% yield optimization notes with contingent protection due April 28, 2011 linked to Dow Chemical Co. shares may appeal to investors seeking high-yield income in a relatively short period, sources said.

In addition, the notes may be of interest to investors who believe that the shares will be moving sideways over the next 12 months, gaining no more than the approximately 10% coupon and losing no more than a specific trigger, which in this deal is a 20% buffer.

The structure is the equivalent of a reverse convertible, although the 424B2 filing with the Securities and Exchange Commission does not specify it.

Each note priced at par of $30.31, which was the closing price of Dow Chemical stock at pricing, according to the filing. Interest is payable monthly.

If the final share price of Dow Chemical stock is at or above 80% of the initial price, the payout at maturity will be par. Otherwise, the payout will be one Dow Chemical share per note.

Good yield hunting

"If you're looking for yield, this is attractive. Today you can't get 10% for a one-year," said Greg Werlinich, president of Werlinich Asset Management.

"It's probably not for my type of investors. I offer plain vanilla, equity products only. But for a yield-hungry, short-term investor, it sounds kind of interesting."

One of the advantages of the structure is that the issuer will pay the 10% coupon regardless of the performance of the underlying stock. The issuer explains why in the filing.

"Notes will pay coupons designed to compensate you for the possibility that you could lose some or all of your principal," according to the filed pricing supplement.

Sources familiar with reverse convertible pricing said that the amount of the coupon paid to the investors depends on the stock's volatility.

With underlying stocks that have a relatively high historical volatility, the issuer is able to offer investors an attractive put premium in the form of the high coupon, they said.

Shares of Dow Chemical are up 13.5% this year. The stock gained 79% last year.

Short a put

"The downside risk after the 20% decline is the equivalent for the investor of shorting a put," said a market participant who specializes in options trading. "If the stock falls by 20% or more, you are forced to buy the stock."

"Assuming that the initial stock price is $100, in this case, you're short a put with an $80 strike price," he added.

But this market participant explained that enjoying the partial downside protection as an investor in the notes and buying short a put as an option investor differ in several ways.

Variable strike

One notable difference, he said, is that the put seller would be assigned to buy the shares at a fixed strike price, while with the notes, the strike price for the investor may vary.

"The put strike price in this deal is $80 because if the shares drop by 20%, you're forced to buy the stock at $80. But the strike price can fluctuate," he said, using the $100 hypothetical starting share price.

He gave an example: If the stock declined below 82% of the initial price one day and dropped below 75% of the initial price the next, the put strike price would be $75 instead of $80, because it's only when the shares break the 20% barrier, falling by 25%, that the put is exercised.

"In this case, you would have to buy the stock at $75," he said, "Your strike [price] would be $75. With those notes, you have a strike price that can fluctuate, something that could not exist with an option."

Precious barrier

Another difference with a regular short put position is the existence of the 20% barrier, he noted.

"Your stock can decline by less than 20% and you're getting your money back. With options, this partial protection wouldn't exist. You would have to sell the stock in order to get your money back," he said.

Selling a call

The payout structure on the upside can also mimic an option trade.

The market participant said that investors also receive a premium based on the capping of the upside.

"On the upside, investors do not participate in the stock gains beyond the 10% coupon," the market participant said.

However, that is not to say they can't outperform the stock. Anytime the share price declines by less than 20%, the investors in the notes will outperform the stock as they get their money back, he said.

And if the share price gains less than the 10% coupon paid on the notes, investors will also outperform the underlying stock.

"It looks like this investment is for people who are only moderately bullish on the stock as they cap their upside to the 10% coupon," said the market participant.

"This is the equivalent of selling a call," he added.

"Overall, it looks like the investor is doing two things with these notes: selling a call and shorting a put. This 10% coupon is actually a premium-equivalent that can be looked at as the sum of the premium received for shorting the put and the premium earned for selling the call," he said.

UBS Financial Services Inc. and UBS Investment Bank are the underwriters.

March deals

Last month, Citigroup Funding Inc. priced a similar deal with $17.76 million of 8% annualized Equity LinKed Securities due April 20, 2011 linked to the common stock of Dow Chemical.

The buffer was 25%.

Citigroup Global Markets Inc. was the underwriter.

Also in March, Barclays Bank plc priced $10.97 million of 9% annualized yield optimization notes with contingent protection due Sept. 21, 2010 linked to the common stock of Dow Chemical. The buffer was 25%.

UBS Financial Services and Barclays Capital Inc. were the underwriters.

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