RBS' 16.75% reverse convertibles linked to DryShips to attract bulls amid takeover chatter

By Emma Trincal

New York, March 11 - Royal Bank of Scotland NV's planned reverse exchangeable securities linked to the common stock of DryShips, Inc. may attract the growing number of investors bullish on the carrier of drybulk commodities as rumors of a merger spread in the market, sources said.

The notes will have an annualized coupon of 16.75% and mature June 17, 2010, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par in cash unless DryShips shares fall below 75% 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 DryShips shares equal to $1,000 divided by the initial price.

DryShips' stock is often used as an underlying asset for reverse convertible deals, according to data compiled by Prospect News.

So far this year, $9 million worth of reverse convertibles linked to this stock have priced in 10 deals brought to market by a number of issuers such as Royal Bank of Canada, Barclays Bank plc, JPMorgan Chase & Co. and UBS AG in addition to Royal Bank of Scotland.

"This is a very volatile stock," said Brian Kelly, founder and chief executive officer at Kanundrum Capital in Rowayton, Conn. "Volatility gives you the ability to earn high income because they have to compensate you for the risk of the stock falling sharply. That's why you get the high coupon."

Merger talk

Volatility rose even more after news reports speculating that the company may be the target of a takeover hit the market on Monday. Some publications suggested that AP Moeller-Maersk A/S, a Danish conglomerate that runs the largest container shipping operation in the world, could be the buyer.

Several analysts heard the market chatter but declined to comment.

Matthew Abenante, a spokesperson for DryShips, declined to comment.

Since Monday, the stock price has risen by more than 9% to $6.18.

"There's a lot of options activity, a lot of trading on heavy volume," said Kelly, who declined to comment on the "market chatter."

But he said, "There is certainly consolidation potential in the space. This is a sector that is ripe for mergers. Given the current deal environment, it wouldn't surprise me to see DryShips being taken over."

Because of its high volatility, the stock has been on the radar screen of traders in other markets. Earlier this year, the name was actively traded in the convertibles secondary market.

"It's also a merger arbitrage play," Kelly said.

Calls and puts

"The market sentiment has turned very bullish," said Richard Sparks, senior equities analyst at Schaeffer's Investment Research, Inc. "You see a fair amount of options activity on both sides, but you see predominantly calls versus puts," he said, citing high call/put ratios in March and April.

"For the March 6 strike price, there were 49,000 open call contracts for 18,000 puts. That's 2.5 times more calls than puts," said Sparks.

For the April 6 contracts, the number of call contracts and put contracts were 20,000 and 3,500, respectively, said Sparks, which is about 5.5 times more calls than puts.

Not too bullish

Investors in reverse convertibles are somewhat bullish in that they hope the barrier will not be breached on the downside, said Sparks. At the same time, reverse convertibles limit the upside to the guaranteed coupon.

With the merger speculation that has been pushing up DryShips' share price, some said that the timing of a reverse convertible investment may not be best, although the high volatility of the stock is what allows the issuer to structure a short-term note with a very attractive coupon.

"If you're really bullish on the stock, you want to own the stock," said Sparks. "You don't want to mess around with the reverse convertible because you don't get participation to the upside if you're right."

On the downside, investors are protected only up to a 25% decline in the stock.

"It doesn't seem like a good risk-reward: you're taking significant downside risk for a limited upside, which is your coupon," said Sparks.

"The 16.75% is what you're getting paid for the risk to see the stock dropping below 75%, and it wouldn't take much," said Kelly. "It's trading now at $6.20. All it takes for the stock is to drop to $5.00. It dropped to $5.00 in early February, so there is no reason it couldn't get to $5.00 in 90 days. It can. No problem."

Principal at risk

Despite the bullish environment around the stock, Sparks said that there is risk on the downside given the chart of the stock.

"It's in the midst of a slow downtrend since September where the stock was trading at around $8.00. However, we've seen recent strength up about 22% to 23% from the low point in February," he said.

Share prices dropped to an intraday low of $5.06 on Feb. 5.

Hybrid instrument

Sparks compared the DryShips reverse convertible with both the stock and a fixed-income instrument.

He concluded that only people with a mildly bullish outlook on the stock and the willingness to take on risk should consider this investment, which may not be appropriate for the more traditional bond or stock investor.

"It's certainly not more risky than a pure equity play since with a stock you wouldn't have the 25% downside protection. But the risk-reward is limited because your entire return is in the coupon, nothing else.

"As a bond instrument, if you compare this for instance to a junk bond, it seems pretty risky because it's tied to a stock that can literally move 25% in a matter of weeks. Seems risky compared to a bond vehicle," Sparks said.

"Maybe you only want to invest in this if you anticipate that the stock will be relatively stable. You have to believe that there is not a lot of downside risk and that there is not a lot of upside potential," Sparks said.

The notes are expected to price Friday and settle Wednesday.

RBS Securities Inc. is the agent.

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