Reverse convertibles undergo 'evolution,' market insider says

By Sheri Kasprzak

New York, Jan. 31 - Reverse convertibles are breaching their barriers as the stock market declines and this is leading to an 'evolution' of the structure, a market insider told Prospect News Thursday.

"We are seeing an evolution of reverse convertibles" said Serge Troyanovsky of BNP Paribas.

"As the equity market declines, more reverse convertibles have breached the barrier, further highlighting potential risks when investing in this product. In addition, large moves in market volatility (both up and down) have led to a number of reverse convertibles being pulled from the market prior to the pricing date."

Troyanovsky noted that if an Apple, Inc. reverse convertible is offered at the beginning of the month with a 20% coupon and during the month, the implied volatility drops sharply, the issuers are no longer able to pay a high coupon on the pricing date and the product is removed.

"Alternatively, when volatility spikes, issuers are able to pay a higher coupon, and therefore reverse convertibles with lower coupons are no longer competitive and have to be pulled from being marketed, or need to be reintroduced with a higher coupon," Troyanovsky pointed out.

This phenomenon, Troyanovksy said, is leading to a shorter marketing period.

"Whereas previously many issuers marketed a single stock reverse convertible for a whole month, today we are seeing marketing periods of one week or even just a couple of days. In many cases, investors are looking to do a one-of trade, meaning a customized trade with a specific structure," he said.

"The whole process, from pricing to trading, may take just a few hours. The new flexibility allows investors to take advantage of market opportunities, especially when the markets decline, leading to an increase in volatility. Reverse convertibles offer high coupons and higher downside protection during the periods when implied volatility increases."

Troyanovsky said there has been a greater interest in blue-chip names because investors feel safer with those names.

"The interest among investors remains quite strong and we are likely to see more reverse convertibles done in 2008," he added.

Reverse convertibles continue to price

This week has sparked a flurry of offerings from banks like Barclays Bank plc and JPMorgan Chase & Co., with several sporting larger coupons.

Earlier this week, Barclays priced a few notes with 20% coupons, including notes linked to United States Steel Corp., AK Steel Holding Corp. and Hansen Natural Corp., all with three-month terms.

JPMorgan priced an 18% note linked to US Airways Group, Inc. and an 18.5% note linked to NutriSystem, Inc. this week.

JPMorgan said Thursday it will price 12% reverse exchangeables linked to Yahoo! Inc. with a one-year term and a 40% protection level.

The notes pay par at maturity unless the stock falls below the protection level during the life of the notes and ends below the initial share price.

The notes are set to price on Feb. 19.

Lehman Brothers Holdings, Inc. said it will price 17% reverse convertibles linked to shares of Peabody Energy Corp.

Those six-month notes pay par at maturity unless the stock falls below the 70% knock-in level during the life of the notes and ends below the initial share price.

Lehman also plans to price 10% reverse exchangeables linked to AT&T Inc.

Those notes pay par at maturity unless the stock falls below the 80% knock-in level during the life of the notes and ends below the initial share price.

Both notes are expected to price on Feb. 8.

Lehman priced $205,000 in 20% reverse exchangeables linked to JetBlue Airways Corp.

The bank also priced $135,000 in 19.2% reverse exchangeables linked to US Steel.

Barclays' Asian currency notes

Elsewhere, Barclays continued to ride on the Asian currency bandwagon, announcing plans to price 98% principal-protected notes linked to a basket that includes the Korean won, the Japanese yen and the Singaporean dollar, all versus the U.S. dollar.

"The dollar has continually been weak against several Asian currencies in the past year or so," said one market source of the proliferation of Asian-linked notes.

"Investors just want to take advantage of this weakness. A lot of investors in [structured products] are getting more and more familiar with the Asian currencies and are becoming more sophisticated with these products, so it's a great time to invest in them."

The one-year zero-coupon Barclays notes pay 98% of the principal amount plus the principal amount times the product of the participation rate, which is expected to be between 120% to 125% with the actual rate to be determined at pricing, and the basket performance, assuming the basket performance is greater than or equal to 0%.

If the basket performance is less than 0%, the investors receive $980 for every $1,000 in principal of the notes.

Earlier this week, Deutsche Bank AG, London Branch said it plans to price call warrants linked to four Asian currencies, including the Taiwanese dollar, the Indonesian rupiah, the Indian rupee and the Malaysian ringgit, all versus the euro.

On Wednesday, Barclays announced plans to price currency revaluation notes linked to Asian and Gulf currencies, including the Chinese yuan, the Hong Kong dollar, the Saudi Arabian riyal, the Singapore dollar and the United Arab Emirates dirham, a strategy that reflects the total return, including exchange rate movements and implied local deposit rates, of U.S. dollar investments in the reference strategy constituent currencies.

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