Morgan Stanley's 14% RevCons linked to Goodyear Tire offer yield amid strong bearish activity

By Emma Trincal

New York, May 31 - Morgan Stanley's upcoming reverse convertible securities due Sept. 29, 2011 linked to the common stock of Goodyear Tire & Rubber Co. offer a high coupon based on high bearish interest in the options market, said Ryan Detrick, senior equity analyst at Schaeffer's Investment Research.

The three-month notes will carry a coupon of 14% per year. Interest will be payable monthly, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par unless Goodyear stock falls by 20% or more during the life of the notes and finishes below the initial share price, in which case the payout will be a number of Goodyear shares equal to par divided by the initial share price or, at the issuer's option, the value of those shares in cash.

Bearish interest

"There's a strong put activity. There are a lot of bearish bets around Goodyear. Since you have a very active put buying environment, selling a put commands a pretty high premium," said Detrick.

Part of the bearish sentiment has to do with the strong performance of the stock so far this year. The share price has risen nearly 50% to $17.70.

"It's a pretty volatile stock. It's at its price of the fall of 2009, near the upper end of its range going back two years," Detrick added.

"But the strategy makes sense if you don't anticipate a sharp decline in three months."

In addition, even the bears in the option market are not as bearish as to reach the trigger level of 80% of the market price, he said.

"The majority of the puts are 10% down the current price, not more. There are not a lot of bets on a 20% decline. So if it goes down a little bit, you can still collect a nice premium as long as it doesn't go down a lot," he said.

Trade with a view

A broker said that reverse convertibles are sold to investors who have a range bound view on the underlying stock. They collect a coupon the same way as an option player would receive a premium for the sale of a put, he noted.

"You don't think it's going to go up very much. You don't think it's going to go down very much. That's what you do when you sell the put," he said.

But the broker warned that investors in reverse convertibles should not be merely chasing yield. Instead they should have a view on the stock.

"The 14% coupon is pretty good. But the higher the coupon, the riskier the trade," he said.

"We expect the customer to know the stock. And ultimately, they have to be comfortable owning the shares."

No major downside

An equity analyst said that the stock was volatile but that he does not foresee a 20% decrease in the share price over the next three months.

"Could the stock go down by 20% or even more? It's unlikely. I don't see any catalyst for that," he said.

"The stock has been doing well, better than anticipated. People were worried about the impact of rising oil prices on the sector. But Goodyear has been able to offset this with price increases.

"The 14% coupon seems like a lot. But it's a pretty volatile stock.

"It's a fairly levered company that doesn't generate a lot of cash flow."

'Not badly priced'

A financial adviser said that the reverse convertible as a trade was more risky than the equivalent put-selling in the open market.

"You're selling a put as the investor. Say the price is at $17.50 at pricing. A put with a 20% strike below market price would give you the 20% protection. It would be a $14.00 put and it sells for 70 cents. That's a 16% yield," he said.

Detrick said that there are no puts expiring at the end of September, which is the maturity date of the notes. The 70 cents puts expire on Oct. 22.

"You have $14.00 strike puts selling at 70 cents, but they expire a month later. It gives you more yield than the notes, but it's also one month more of potential risk," he said.

"Overall, the trade behind the notes makes sense, and it's not badly priced. Retail investors are probably not too experienced in selling puts, so it might work for them."

Too risky

The financial adviser said that he would prefer dealing with puts directly in order to reduce some of the downside risk.

"Unless you really want to own the stock, this note is a risky strategy," he said.

"You look at it as a yield play, but it's really a trade for someone who has a view on the stock.

"You would do better selling the put directly in the open market because you can always buy the put back.

"With this note, you can't really exit the trade. I guess you could short the stock too, but I still think it's too risky."

For this adviser, the downside risk is real given the recent performance of the stock.

"The stock was at $10.00 just a few months ago. If it goes back there, you're down almost half your money. You're getting paid what looks like a high yield for a lot of risk," he said.

"But the stock is already up 50% this year. Who is to say it's going to continue in that direction?"

Overweight

In a May 8 research note, Morgan Stanley equity analyst Ravi Shanker rated the stock overweight, raising the price target to $22.00 from $20.00.

The analyst wrote, "Rising commodities prices and tight supply are giving tire makers - including [Goodyear] - an opportunity to push through larger and quicker price increases than ever before."

The notes (Cusip: 617482US1) will price June 24 and settle June 29.

Morgan Stanley & Co. Inc. is the agent.

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