Volatility makes slight difference between twin reverse convertible note issues, analyst says

By Emma Trincal

New York, Oct. 30 - The comparison of two quasi-identical reverse convertible structures linked to two stocks from the same sector illustrates how the stock volatility differences, even by a small percentage, allow the respective issuers to offer different terms, said structured products analyst Suzi Hampson at Futures Value Consultants.

Hampson looked at two very comparable reverse convertible structures linked to two energy stocks: Schlumberger NV (Schlumberger Ltd.) and Valero Energy Corp.

"This is not a new trend. Those two stocks have been quite consistently used and have been in the market for a while," Hampson said.

What really distinguished one structure from the other was the respective volatility of each underlying stock, Hampson said.

Schlumberger

The first structure consisted of 9.5% reverse convertible notes due April 30, 2010 linked to Schlumberger shares, which Barclays Bank plc priced on Thursday in a $3 million offering.

The payout is not protected at maturity if an 80% barrier is breached and the stock finishes below its initial price, in which case principal is lost at a rate of one point per point of decline in the underlying stock, according to a 424B2 filing with the Securities and Exchange Commission.

As with any convertible note, the coupon is in any case paid out at maturity.

Valero

The second structure consists of 10% to 14% annualized reverse convertible notes due May 12, 2010 linked to the common stock of Valero Energy, which Eksportfinans ASA is planning on pricing on Nov. 6, according to an FWP filing with the SEC.

If Valero stock falls below the knock-in price - 75% of the initial share price - during the life of the notes and finishes below the initial price, the payout at maturity will be a number of Valero shares equal to par divided by the initial share price. Otherwise, the payout will be par.

Twin deals

"These are almost identical structures," said Hampson pointing to the same six-month term and high-coupon received independently of the stock performance. Besides the different credit risk of their respective issuers, these notes offer one distinctive factor, which is the slight difference in volatility for the two underlying stocks. "Valero is a little bit more volatile than Schlumberger," Hampson noted.

Valero's annualized volatility - or historical volatility is 59.35%; Schlumberger's is 55.50%

Volatility and premium

"Obviously the product is structured around the stock, and the option price is affected by the volatility," Hampson said. "The volatility will dictate the terms of the deal. The higher the volatility, the better terms the issuer is able to offer."

Hampson stated that "when structuring a reverse convertible note, the issuer is selling a put on the downside." As a result, she added, "the higher the volatility of the underlying stock, the greater the premium received by the issuer on the puts," she noted.

The Eksportfinans deal linked to Valero has not priced yet, but looking at the 10%-14% coupon range announced in the filing, Hampson assumed the digital coupon would price at the mid-point at 12%.

"Given the fact that the underlying stock is more volatile, this issuer [Eksportfinans] was able to offer a higher coupon," she said, comparing the presumed 12% with the 9.5% interest offered in the other structure. In addition, the issuer offered a lower barrier of 75%, which is also attractive compared to 80%, she said.

Both risky

But when it comes to risk, the difference between the two products becomes slim, Hampson said, comparing the riskmap for each notes. Riskmap is Future Value Consultants' rating to measure the risk associated with a product on a scale from zero to 10.

"These two are quite similar," she said. The riskmap is 6.90 for the Schlumberger deal against 6.96 for the deal linked to Valero, the more volatile underlying stock.

"We look at the probability of hitting the barrier and it's about the same in both cases because the stocks have a similar level of volatility. But obviously, the more volatile the underlying stock, the greater the probability of breaching the barrier," she said. This would explain why the Valero notes are slightly more risky, she added.

The two deals carry a similar overall rating as well. The overall rating is Future Value Consultants' opinion on the quality of a transaction, taking into account costs, structure and risk-return profile, rated on a scale of zero to 10.

The Schlumberger-linked notes are rated 5.43; the Valero overall rating is 5.96.

"This is because you have two very similar structures," Hampson said, adding that one component of the overall rating - the return rating - was equally low for both deals.

Low risk-adjusted return

The notes linked to Schlumberger have a 2.60 return rating, which is Future Value Consultant's indicator, on a scale of zero to 10 of the risk-adjusted return. For the Valero notes, the rating was 2.87.

"Both stocks have a pretty high volatility, over 50%, which is much higher than the historical volatility of the S&P 500 [of 33%]. That tells you that in six months, the probability of hitting a barrier of 80% or even 75% is quite likely, in which case you would lose some capital, which in turn would affect your return," Hampson said.

The agent for the notes linked to Schlumberger is Barclays Capital. The notes settled on Friday.

For the reverse convertibles tied to the performance of the Valero stock, the agent is Morgan Stanley & Co. The notes are expected to settle on Nov. 12.

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