Royal Bank of Canada boosts coupons on 40 RevCons in an effort to reprice volatility spike

By Emma Trincal

New York, May 13 - Royal Bank of Canada increased the coupons of 40 previously announced but not yet priced reverse convertible deals, responding swiftly to last week's rise in volatility, sources said.

The biggest increase applied to the bank's reverse convertible notes due Aug. 18, 2010 linked to the common stock of ATP Oil & Gas Corp.

The issuer upped the coupon on this deal by nearly 127% to a 38% annual coupon from 16.75%, according to an amended FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par unless ATP Oil & Gas stock falls below the barrier price - 65% of the initial share price - during the life of the notes and finishes below the initial share price, in which case the payout will be a number of ATP Oil & Gas shares equal to $1,000 divided by the initial share price or, at RBC's option, the value of those shares in cash.

The notes were expected to price Thursday.

RBC Capital Markets Corp. is the agent.

At the other end of the spectrum, the reverse convertible notes due Aug. 18, 2010 linked to the common stock of Hutchinson Technology Inc. were increased the least to 25% per year from 24.5%, a 2% hike.

On average, the coupons rose by 47%.

Market adjustment

"Those increases were the direct result of last week's spike in volatility in the market," said a New York sellsider.

Amid last week's fears around the Greek debt crisis and prior to the European bailout announcement, the CBOE Volatility index, also known as the "fear gauge," doubled to 40.95 on May 7 from 20.19 on May 3.

With a reverse convertible note, investors are short volatility. The higher the implied volatility, the higher the coupon should be in order to compensate investors from the risk of breaching the barrier, said an analyst.

"The ideal situation for investors is to sell volatility at a high price in the expectation that it is going to go down," this analyst said.

VIX rollercoaster

The index, which is also known as the VIX, closed at 26.68 on Thursday, a reverse trend from last week with a 35% decline. But the index remains higher by 30% than what it was at the beginning of last week.

Comparing the VIX with the implied volatility of one of the underlying stocks, the sellsider said, "The numbers speak for themselves."

He pointed to the 78% implied volatility of ATP Oil & Gas, the stock underlying the note that incurred the greatest coupon hike.

So far, other banks have not yet repriced their coupons, but sources said that it is not unlikely to happen.

Energy mostly

The greatest number of increased coupons took place with notes that were tied to energy stocks - 17 deals out of the 40 upgraded notes, according to data compiled by Prospect News.

Some of the names included Massey Energy Co. (68% increase to a 23.5% coupon), Peabody Energy Corp. (67% increase to an 18% coupon) and Halliburton Co. (52% increase to a 16% coupon).

The second sector where many coupon hikes occurred was financials. Seven names were upgraded, including the notes tied to Goldman Sachs Group, Inc. (64% increase to a 16% coupon) and Bank of America Corp. (to a 16.25% coupon, up 51%).

The other names were seen mostly in the gaming, health care and technology sectors, according to data compiled by Prospect News.

Good business

"When volatility is on the rise as it was last week, dealers have to increase the coupon to their investors," said a structurer.

"Investors are sellers of the options to the issuer. When volatility goes up, the cost of the option goes up as well. But the issuer is able to pass on that value to the investor because they resell the option to the market themselves. And those options are worth much more now."

This structurer said that it was good business for the issuer to reprice those deals in a way that was more favorable to the investors. "The dealer is in the business of making a fair deal to the customer," he said.

Competition in the market as well as transparency was also a contributing factor to those adjustments, he noted.

"Dealers compete with one another. If one issuer does not increase the coupon, someone else will."

This structurer said that investors or financial advisers can assess the coupon increase in simple ways.

Do-it-yourself tip

"In order to evaluate the value of the increased coupon, it's useful to find out how much the volatility of a name has changed relative to the market volatility," he said.

He gave a hypothetical example from a period covering the early stages of the volatility uptrend in the market to the date the notes of an issuer get repriced.

He assumed, as an example, that the market volatility rose by 50% from 20% to 30% during that time. At the same time, the implied volatility of a note's underlying stock would have moved to 45% from 24%, an 87.5% increase.

"You want the coupon not to go up by just 50%, which is the market, but by a lot more than 50%," he said.

He added that the greater the volatility premium of a name - or the excess implied volatility of the name over the market - the higher the raise investors should expect to see on their coupon.

"Dealers are motivated to pass that value on to the investor because they operate in a competitive market," he said.

"Besides, with the lower cost of information technology, customers can identify the change of value themselves," he added.

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