RBC's 15% reverse convertibles linked to Citigroup involve risk due to volatility, tenor

By Emma Trincal

New York, Jan. 20 - Royal Bank of Canada's 15% reverse convertible notes due April 30, 2012 linked to the common stock of Citigroup Inc. are designed for investors who seek income on a short-term investment and are willing to put their capital at risk for that, said Eve Berlinska, analyst at Future Value Consultants.

There is more risk involved with this note than with the average reverse convertible, given the volatility of the underlying stock and the term of the notes, she added.

But the reward is a chance to outperform the stock and earn an above-average coupon rate if the share price stays within a range, she noted.

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

More risk

"The risk is slightly higher than with other comparable products because of the implied volatility and also because of the short duration," Berlinska said.

Citigroup's implied volatility is 46%, she said, which is more than 35%, the average implied volatility of stocks used as underliers in reverse convertibles based on the firm's most recent analysis.

In comparison, the implied volatility of the S&P 500 is 28%.

"It's quite more volatile than other reverse convertibles, and it has an 80% barrier," she said.

"The barrier is standard. Still, it's probably not enough."

With reverse convertibles, investors make money when the barrier is not breached because the coupon is paid regardless of the stock performance, she explained.

The coupon is the equivalent of a premium received from the sale of a put option. In theory, the higher the volatility, the higher the premium on the short put. However, risk increases accordingly as the odds of breaching the barrier rise with the implied volatility.

The riskmap, Future Value Consultants' rating that measures the risk associated with a product on a scale of zero to 10, for these notes is 5.36, higher than the 5.08 average riskmap for similar reverse convertibles.

The riskmap is the sum of two risk components: market risk and credit risk. The higher the market riskmap, the higher the risk linked to poor market performance. The credit riskmap, on the other hand, measures the issuer's risk.

"The market risk is higher than average given the barrier offered for an underlying with this amount of volatility and the short recovery time if the barrier is hit," she said.

Duration is also a factor.

"If during the three-month [tenor] the barrier is hit, you may not have enough time to recover the losses by the time the notes mature," she said.

While credit risk is an important risk component with products with longer tenors, its role is less relevant over a three-month period, she said.

"Most of the risk is concentrated in the market risk here," she said.

At 5.09 on a scale of zero to 10, the market riskmap for these notes is substantially higher than the average of similar products, which is 4.62, she noted.

The 0.27 credit riskmap, although much lower than 0.46 - the average credit riskmap for reverse convertibles - does not lessen the riskmap.

"Credit riskmap is almost irrelevant on a three-month [note]," she said.

Return score

Future Value Consultants' opinion of the risk-adjusted return is measured by the return score. Established on a scale of zero to 10, it is calculated under reasonable and consistent forward-looking assumptions.

The return score at 5.99 is more on par with that of similar products, which average 5.96.

"It simply means that the product offers average returns for the given risk," said Berlinska.

"The risk ... here is higher than average, but the returns compensate for this, hence the average return score."

Future Value Consultants uses a probability chart to show how the product is expected to perform. The firm offers different market scenarios, including expected performance compared to cash returns.

Based on this cash return assumption, there is a 75% chance that the product will generate the full 15% annualized coupon.

Separately, the odds of losing more than 15% of principal are 25%.

Price, overall

The price score, Future Value Consultants' estimate of the total costs taken out of the product from direct fees and profit margin on the underlying derivative, is below average at 5.96. The average score for products of the same structure type is 6.34.

The result suggests that the product does not offer as good a value as its peers, she said.

"The issuer could have lowered the barrier or increased the coupon a little bit. The price score would have come up in that case," Berlinska said.

However, the price score is updated weekly before pricing and is often subject to change.

Overall, this product is for an investor who wants to invest short-term and is willing to lose capital if the stock declines below the barrier by more than the coupon amount.

"People investing in these types of notes want the income over a short period of time," she said.

"They also know that they have a fair chance to outperform the stock if it trades within a range.

If the share price finishes down, the investment will still outperform the stock because the coupon is paid in any case.

"And if the stock is up, as long as performance is less than the coupon rate, they will also outperform the stock."

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

Because the price score is below that of the average for similar notes, the overall score for this product is also below average at 5.97 versus 6.15 for other reverse convertibles.

The notes are expected to price Jan. 27 and settle Jan. 31.

RBC Capital Markets, LLC is the agent.

The Cusip number is 78008TL51.

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