RBC's 13% reverse convertibles linked to eBay offer lower risk than average, higher scores

By Emma Trincal

New York, Dec. 23 - Royal Bank of Canada's upcoming offering of 13% reverse convertible notes due March 30, 2012 linked to the common stock of eBay Inc. "scores very well for a reverse convertible," said structured products analyst Suzi Hampson at Future Value Consultants.

"Reverse convertibles are among the riskiest products, but this one is less risky than its peers. In fact, it even shows a lower risk level than the average of all product types," she said.

In addition, the notes received an above-average return score, which means that the risk/reward profile is attractive, she said.

The choice of the reference asset is one of the main factors that drove down risk, she said. eBay is a stock with a relatively low implied volatility compared to many other stocks that are used as the underlying of reverse convertibles or other notes linked to single stocks, she explained.

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

Low volatility

Future Value Consultants measures the risk associated with a product on a scale from zero to 10 with its riskmap.

Compared to other reverse convertibles, which have an average riskmap of 5.47, the product scores only 3.28. Its risk level is also lower than the average riskmap of all products, 5.07.

The rating compares the average product underperformance (relative to cash) with the average underperformance of five sample assets of different volatility levels. The risk rating equates the risk of the products against the five hypothetical assets.

"The one-year implied volatility for eBay is 33%, compared to 24% for the S&P 500. It's quite low for a stock, and that's probably why the product is scoring so well. Usually, for reverse convertible underlying stocks, we get stocks with much more risk in the 60% to 70% implied volatility levels," she said.

"This stock is probably one of the less volatile that we've seen for these types of structures."

The 80% barrier protecting the downside "isn't bad," she said, "but it remains pretty standard," even for a three-month reverse convertible.

"If you take the 80% barrier plus than the lower than average volatility, then you can say that the barrier is worth more to the investor because it has less chance to be hit," she said.

Stock pick

Investors who may consider the notes would fit into the traditional profile of the reverse convertible buyer.

"You would have to like the stock, possibly already own it. You would have to be prepared to take on losses if the barrier is breached. There is less risk involved than if you bought the stock directly, but there is risk nevertheless.

"The real difference between choosing this type of investment and buying the eBay shares directly is that you want income instead of growth in exchange for some protection. You buy a product like this one in order to modify the risk/reward profile."

Some of the disadvantages of the product compared to an outright purchase of the stock are common to other structured notes.

"You're not going to get the dividends that you would have earned in the stock," she said.

"And you take the credit risk from the issuer, but it's only three months, so it's not that much risk anyway as credit risk is very dependant on the length of time."

Credit, market risk

The riskmap is composed of a market riskmap and a credit riskmap.

The low credit riskmap of 0.28 - compared with 0.43 and 0.56 for products of the same type and all products, respectively - reflects the short duration perhaps more than the credit worthiness of Royal Bank of Canada.

The Canadian bank shows credit default swap spreads of 130 basis points.

In contrast, the CDS spreads for Citi are 275 bps. Goldman Sachs has even wider levels with 330 bps, and Bank of America's spreads hit the 400 bps threshold.

"Royal Bank of Canada is much more creditworthy than most U.S. banks. But the low credit riskmap for this note has more to do with its short maturity than with the issuer's credit," she said.

At 3 on a scale of zero to 10, the market riskmap was also less than the average for all products, which is 4.52. It compared even more favorably with 5.04, the average market riskmap for other reverse convertibles.

Risk/return

A product with a low riskmap does not necessarily mean a higher return score, but in the case of these notes, it does.

The return score is Future Value Consultants' opinion of the risk-adjusted return under reasonable and consistent forward-looking assumptions for underlying asset evolution on a scale of zero to 10.

The return score is 6.63 for the product, compared with 5.80 for other reverse convertible notes.

"The riskmap looks at the probability of capital loss as well as the amount of capital loss.

"The return score wraps up the return with the risk.

"The good return score here simply means that you're getting a good return for the amount of risk you're taking," she said.

Probability tables

The return score derives from the probability of return outcomes calculated by Future Value Consultants using a Monte Carlo simulation and displayed in a chart across different return buckets.

The performance is modeled based on a series of parameters, which includes volatility, dividends and interest rates among others.

This product has an 82% probability of giving investors an annualized rate of return in the 10% to 15% bucket. The risk of losing more than 15% of principal is 16.5%.

Price, overall

Another positive aspect of the deal is its price score of 7.42.

The score on a scale of zero to 10 represents the real value to the investor after deducting the costs the issuer charges in fees and commissions on an annualized basis and profit margins on the underlying derivative.

The price score for this product is better than both products of the same structure type (5.97) and all products (6.56).

"It's a good price score and again, those notes offer better scores than the average. The issuer has spent more on the options and as a result is able to throw in better terms. The product offers good value to investors," Hampson said.

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

Given that both the return and price scores are better than average, the notes also have an above-average overall score of 7.02.

Reverse convertibles on average have received a 5.89 overall score. The average score for all products is 6.44.

"Compared to other products in the market, these notes offer a fair amount of return for a lower-than-average risk. It's a product that appears to be relatively attractive," she said.

The notes are expected to price on Wednesday and settle on Dec. 30.

RBC Capital Markets, LLC is the agent.

The Cusip number is 78008TD84.

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