Barclays' 12% reverse convertibles linked to 3D Systems stand at risky end of product spectrum

By Emma Trincal

New York, Aug. 2 - Barclays Bank plc's 12% reverse convertible notes due Nov. 12, 2013 linked to the common stock of 3D Systems Corp. present more market risk than average due to the high implied volatility of the underlying stock, said Suzi Hampson, structured products analyst at Future Value Consultants.

"This is a typical reverse convertible. But the risk is significantly higher than average," she said

"These products as a whole are high risk. As long as the stock stays above the barrier during the period, you're fine. But if the stock is volatile, as this one is, you can lose quite a large portion of your principal."

The implied volatility for 3D Systems shares is 55%, she said.

The payout at maturity will be par in cash unless 3D Systems shares fall below 73% 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 3D Systems shares equal to $1,000 divided by the initial price, according to an FWP filing with the Securities and Exchange Commission.

Income play

"With these reverse convertibles, you always get your coupon. In here, it's 3% for the three-month term," she said.

"You have a 73% barrier, or a 27% level of protection. As long as the stock doesn't breach that barrier during the three-month period, your protection remains in place. But if the barrier is breached and if the stock finishes lower, you may lose some principal. The 3% coupon, however, gives you a little bit of extra cushion. Suppose the barrier is breached. The stock has gone down but then goes back up and closes at maturity at 99. Because you are paid 3%, you wouldn't lose any principal."

The notes are designed for investors seeking income or some alternative to a direct investment in the shares, she said.

"This is an income-providing product. The idea of getting a fixed return as opposed to a return linked to growth may be attractive to bond investors as an alternative to a corporate bond, although they should keep in mind that they still have equity risk exposure on the downside," she said.

"These types of products are for investors who like the stock in some way. You have to know the stock and be interested in owning it eventually.

"It's a little less risky way to get some return than owning the stock outright because of the barrier. It changes your payout profile. It's a lower-risk version than investing in the stock itself. But this one is certainly not less risky than your typical reverse convertible."

High market risk

The riskmap, a rating created by Future Value Consultants, measures on a scale of zero to 10 the risk associated with a product with 10 as the highest level of risk possible. It is the sum of two risk components: market risk and credit risk.

The riskmap of 8.81 for this product is "high" compared to that of the average for reverse convertibles, which is 4.68, she noted.

However, the credit risk at 0.30 is exactly the same as average.

"It indicates that most of the risk comes from the market risk, not the credit risk. It's visible when you compare the two different market riskmaps," she said pointing to an 8.51 market riskmap for the notes versus 4.38 for the average of the same product type, she said.

"My guess is that it's due to the high volatility of the underlying stock. When volatility is high, the chances of breaching the barrier are a lot higher. And this 73% barrier is not a particularly different barrier than the average barrier for those structures, which tends to be in the 70% to 80% range.

"Rather than the barrier being less generous than usual, the low market riskmap and riskmap scores suggest that the volatility of the stock is the main factor."

Risk-adjusted return

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 calculated based on the best among the five return scenarios, which for this particular product would be the low-volatility scenario.

With this market assumption, investors have a roughly 75% chance of earning an annualized return in the 10% to 15% bucket. The chances of losing more than 15% a year are about 25%.

The return score for the notes is only 4.54 versus 5.85 for the average of the same product type.

"This score measures the potential return given the amount of risk," she said.

"This is such a risky product, in order to get a good return score you should be looking at a much higher return because you need to balance out the risk you're taking.

"This score suggests that the coupon offered is not high enough to compensate investors for the level of risk. Other products available give investors a better risk reward return."

Price, overall

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10.

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.

The price score for the notes is 2.63 versus 5.84 for the average reverse convertible.

"Sometimes we can see shorter products scoring less. That's because we look at fees on an annualized basis, so there's less time to spread the fee over in a short-term product," she said.

"But clearly that's not the main reason here. This price score is less than half the average. It's really not high at all, which suggests that the value for the investor isn't that great.

"3D Systems may not be a popular underlying. Maybe there is less liquidity in that option, or maybe the product was designed for a particular purpose, which would explain why the score is so low."

Two notes linked to 3D Systems have priced so far this year, according to data compiled by Prospect News. Both were small three-month reverse convertible deals. Barclays priced one of them carrying a 12% coupon for $300,000 in May. Royal Bank of Canada sold $1 million with a 9.4% coupon.

Overall score

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.

The 3.59 overall score is "disappointing," Hampson said, compared to the 5.85 average overall score for this product type.

"The return score is below average. The price score is well below average," she said.

"The product doesn't look particularly competitive."

The notes are expected to price Tuesday and settle Aug. 9.

Barclays is the agent.

The Cusip number is 06741J3Q0.

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