UBS' trigger yield optimization notes linked to Dow Chemical stock offer income, longer term

By Emma Trincal

New York, July 20 - UBS AG, London Branch's 6% to 7.25% two-year trigger yield optimization notes linked to the common stock of Dow Chemical Co. target income-seekers with a longer timeframe than the typical reverse convertible investor, said Suzi Hampson, structured products analyst at Future Value Consultants. The result is a more conservative profile, she said.

"This is an income-generating product for someone prepared to invest for two years," she said.

"Our ratings show that it's not at the very high end of the risk spectrum."

Two of the main characteristics of the notes are its longer duration and its final-day barrier, she said. While the duration adds more credit risk, it enables the investor to collect more interest, which creates another layer of downside cushion, she explained.

Two years

"The type of barrier and the longer duration tend to mitigate some of the market risk," she noted.

The face amount of each note will be equal to the initial price of Dow Chemical stock.

The payout at maturity will be par unless the final price of Dow Chemical stock is less than 65% of the initial share price, in which case investors will receive one Dow Chemical share per note, according to an FWP filing with the Securities and Exchange Commission. The coupon is paid monthly.

"The product, as with any other reverse convertible, gives investors a coupon they can keep regardless of the stock performance," she said.

"This product is a little different than most reverse convertibles, though. It's a two-year [note], a longer period of time than most U.S. reverse convertibles, which are three, six or 12 months. It's more like a U.K. product where you see similar things for three- or five-year maturities.

"But longer doesn't have to be bad. You're getting an income stream well above the risk-free rate."

Market risk

The risk of the product is measured on scale of zero to 10 by Future Value Consultants through the riskmap. At 3.47, the notes' riskmap is lower than the average 4.36 riskmap of reverse convertibles.

The riskmap is the sum of two risk components: market risk and credit risk.

The market riskmap, at 2.42, is proportionally even lower than the 3.80 average market riskmap of the reverse convertible group, she noted.

"The market risk is quite a bit lower, and it's due to the combination of a low barrier at 65% but also because it's a final barrier. The observation date is only at maturity and not intraday, which reduces the probability of breaching the barrier," she said.

Final-level barriers are not very common in the United States for reverse convertibles.

"We definitely have had them, but the standard is daily," she said.

"In addition, the final barrier associated with this note has a bigger impact because of the longer period."

In order to run her report, Hampson assumed a 7% coupon, which is about 75% within the coupon range.

She said that Dow Chemical is "not a very volatile" underlying stock. Its implied volatility is 27%.

"We've seen much higher, from 35% to 70%," she said.

"So you're not getting a high headline rate as you would get with a three-month. But it's a much longer play, and you're collecting this coupon much longer.

"This investment presents less risk than investing in the stock directly. But it's also less risky than other reverse convertibles and less risky than most enhanced notes, which have small buffers or sometimes no buffer at all," she said.

However, the longer term increases credit risk. This is why the credit riskmap is 1.05 for these notes, compared with 0.56 for the average reverse convertible, she said.

The creditworthiness of UBS is less of a factor than time, she added, saying that the bank's credit default swap spreads, at 190 basis points, are lower than some U.S. banks.

"The biggest proportion of the risk if you look at the two riskmap components is credit risk not market risk. The market risk is actually relatively low," she said.

Return score

Future Value Consultants measures the risk-adjusted return with its return score on a scale of zero to 10.

The rating is calculated using five key market assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

Future Value Consultants' probability chart run under the most favorable assumption - a low-volatility market in this case - reveals that investors have an 86% chance of earning the maximum annualized return between 5% and 10% against a 2% chance of losing 10% to 15%. The probability of losing more than 15% of principal is 12%.

"With this barrier, the probability of losing capital is rather low," she said.

The 6.47 return score for the notes is better than for the reverse convertible category, which has an average score of 6.10.

"You're getting your coupon for a longer period of time, and you are less likely to lose capital," she said.

"If you do lose capital, it will be bigger losses for you, but the chances of this happening are less."

Price, overall

The product was also well rated on the price scale.

Future Value Consultants measures the market value of the underlying components of the product on a scale of zero to 10 with its price score. Calculated as a percentage of the initial investment, the score gives an estimate of the fees taken per year. The higher the score, the lower the fees and the greater value offered to the investor.

At 7.50, the price score for the notes is well above the average 6.61 score for similar products, she said.

"The good score I think is slightly linked to the term. Some of the fees and costs are fixed, and we look at the fees on an annualized basis. Longer maturities often drive a better price score because the fees are spread out over a longer period of time," she said.

For investors, longer-dated products of that type offer other advantages.

"Short-term reverse convertibles are huge in the U.S.," she said.

"I guess investors are used to reinvesting every three months, which introduces some reinvestment risk. But there is also a cost associated with it. Every three months, you'll get hit with fees. With this two-year note, you may have a higher fee initially, but it probably ends up costing you less because you buy one product and not eight," she said.

The price score and return score are averaged to obtain the overall score of the product, which represents Future Value Consultants' opinion on the quality of a deal.

Because both score components are better than average, the product also received a better score at 6.98 versus 6.35 for the average reverse convertible.

The notes are expected to price Monday and settle Thursday.

UBS Financial Services Inc. and UBS Investment Bank are the agents.

The Cusip number is 90269T418.

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