RBC's reverse convertibles tied to Chesapeake Energy show attractive pricing for product type

By Emma Trincal

New York, May 24 - Royal Bank of Canada's 10.25% reverse convertible notes due Nov. 29, 2013 linked to Chesapeake Energy Corp. shares offer competitive terms and pricing compared to the average reverse convertible currently available in the market, said Suzi Hampson, structured products analyst at Future Value Consultants.

The payout at maturity will be par in cash unless Chesapeake Energy 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 Chesapeake Energy shares equal to $1,000 divided by the initial price, according to an FWP filing with the Securities and Exchange Commission.

"The 10.25% coupon offered in relation to the risk associated with the product, in particular in relation with the implied volatility of the stock, is what makes the product competitive compared to its peers," Hampson said.

The implied volatility of Chesapeake shares for six months is 34%, she said.

"It's not too bad. There are plenty of stocks with much higher levels in the 60% or 70% range."

Standard structure

"Reverse convertibles are very common in this market. It's a standard structure," she said.

"This note offers approximately 5% for the six-months term, well above the risk-free rate. So it makes sense that you have to put your capital at risk. And you face such risk if the stock closes below the 80% level anytime during the six months.

"While it's not among the most volatile stocks, volatility remains of course way above a U.S. equity index. You should expect volatility to move over the six-month term, and if the share price drops and volatility picks up, your chances of losing money as a result will increase.

"Although a barrier of 80% sounds good, especially on the six-months term, you can still hit the barrier and lose capital. It is a risky product."

One positive aspect of reverse convertibles is the fixed interest rate, she said.

"This product pays a fixed coupon. As you receive some income, you are in a position to offset some of the risk. You don't get the dividend payment, but your coupon remains much higher than the dividend yield," she said. The dividend yield on Chesapeake Energy is 1.64%.

"If you combine the barrier and the coupon, you do get protection, at least more than if you were to take a long position in the stock," she said.

Different profile

The return on the notes is capped at the coupon level, which is one of the main differences between investing in these securities and buying the stock itself, she explained.

"If the stock grows significantly over the period, you're not going to benefit from that," she said.

But Hampson said that investors in the notes should be willing to accept the limited upside and to take the downside risk if the barrier is breached.

"Investors in this product should have a reason to choose this particular stock rather than another," she said.

"You should be willing to own the stock. You have a fixed coupon and some downside protection. On the other hand, you do have to consider that it's a fixed maturity. This is a security that is designed to be held."

Investors in the notes, as with all other reverse convertibles, typically want to change the risk profile of a stock.

"You don't go for growth; what you want is the coupon," she said.

"You still rely on the performance though Your return is still linked to the return of the stock. You're short volatility. You want the underlying price to stay the same; you don't want to breach the barrier. That's the goal. If you don't hit the barrier, you'll get the maximum return, you'll outperform the stock, and you won't lose any capital. That's the best-case scenario. It's a different risk-reward profile than being long the stock."

Less risky than average

Future Value Consultants rates the risk associated with a product on a scale of zero to 10 with its riskmap. The higher the riskmap, the higher the risk of the product. The riskmap is the sum of two risk components: market risk and credit risk.

The notes have a lower-than-average market risk compared to other reverse convertibles. They also show an even lower credit riskmap.

At 0.17, the notes' credit risk is lower than the average credit risk of reverse convertibles, which is 0.36, according to Future Value Consultants research.

"We have less credit risk here. It's a combination of the short-term maturity and the issuer. Royal Bank of Canada is one of the lower funding, lower CDS spreads out there. The credit risk is relatively small," she said.

Compared to the 0.52 average credit riskmap of all products, the notes show even less credit risk.

"Maturity is always a big issue as it increases the credit risk. Reverse convertibles in general tend to have less credit risk than long-term products. A six-month maturity is not too bad. Some reverse convertibles are longer than that, one year for instance," she said.

The market risk is also less than the average of this product type. For the notes, the market riskmap is 4.11 versus 4.40 for the product type.

"You're comparing this product with other reverse convertibles tied to [more] volatile stocks, some with volatility levels of 50%, 60%," she said.

"There's also the barrier level. Your market risk is a factor driven by the probability of breaching the barrier, so it's a combination of where the barrier is and what the volatility of the stock is.

"But ultimately, the key factor is the implied volatility of the underlying stock."

Return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

For reverse convertibles, the optimal scenario is a low-volatility environment. In this context, investors still have a 21% chance of losing money, she said.

Investors have a 74% chance of earning the full annual return, she noted. The risk-return profile of the product in comparison to its peers was "attractive" as measured by a 6.03 return score, which is above the 5.74 average for this category, she said.

On the other hand, the notes' return score was lower than the average of the overall market, all products included, which is 6.59, she noted.

"But the reverse convertible category is different. What matters really to the investor is to be above average in the structure type they want to invest in. Comparing a six-month reverse convertible with a two-year leveraged note doesn't make any sense," she said.

"The return score here suggests that given the amount of risk you're taking on, you're receiving a coupon that's better than the average reverse convertible, which is what you want to see."

Price, overall

Future Value Consultants measures a note's value to the investor on a scale of zero to 10 via its price score. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

"This score measures the value. We take into account the price of the options and the amount of fees. It's quite a little bit above the average of this product type," she said.

The price score for the notes is 5.99, compared with 5.58 for the average of the same product type.

"Reverse convertibles tend to have lower value scores because we look at fees on an annualized basis and as a result, fixed cost doesn't get spread over such a long period of time," she added.

Future Value Consultants offers its opinion on the quality of a deal with its overall score. The score is simply the average of the price score and the return score.

At 6.01, the notes show a higher overall score than the 5.66 average in the product category.

"We have a satisfactory overall score," she said.

"There are so many reverse convertibles, so many underlying, you have to choose the sector or a specific company that you want and try and compare five or six different reverse convertibles with different barriers and different maturities.

"The score gives you an indication of where to start. It helps you select a few products. When it's above average, like this one is, you know that there's nothing in the product that's going to put you off.

"This one is in the top lot. It's in the right corner of the graph, which is where you want to be."

She referred to a scatter chart showing riskmaps versus overall scores.

The notes are expected to price on Tuesday and settle on May 31.

RBC Capital Markets LLC is the agent.

The Cusip number is 78008SY67.

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