Barclays’ 10.5% reverse convertibles tied to Keurig Green Mountain are a short-term yield play

By Emma Trincal

New York, Feb. 13 – Barclays Bank plc’s 10.5% reverse convertible notes due Feb. 26, 2016 linked to Keurig Green Mountain, Inc. shares offer an attractive fixed coupon, but the volatility of the underlying stock and the type of barrier used in the structure add significant risks, said Tim Vile, structured products analyst at Future Value Consultants.

A knock-in event occurs if the share price closes below the knock-in barrier price, 70% of the initial price, on any day during the life of the notes, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par if the final price is equal to or greater than the initial price or if the stock return is negative but a knock-in event has not occurred.

If the final price is less than the initial price and a knock-in event has occurred, the payout will be par plus the stock return or, at the issuer’s option, a number of Keurig Green Mountain shares equal to $1,000 divided by the initial share price.

American barrier

“We have a barrier, so the full capital is at risk. The risk is greater due to the American barrier type used in this product,” Vile said.

American options can be exercised any time before the expiration of the contract while European barriers can only be exercised on the expiration date.

“At any time, if the 70% barrier is breached you lose the benefit of your protection. You can lose up to 100% of your initial investment,” he said.

“At the same time, I’m not surprised to see this riskier type of barrier because the 10.5% guaranteed annualized coupon is quite attractive.

“Naturally, this type of yield is well above the risk-free rate since there is equity-like risk.

“Investors looking for yield over a short-term horizon may be attracted to this product.”

The 30% amount of contingent protection at first appears generous.

“Problem is this is a stock that’s very volatile, as the chart illustrates,” he noted.

The one-year implied volatility of the stock is 41%. The share price since its last peak in November has fallen 25%. For this year, the stock is already down 10%. This compares with a 77% gain last year, which followed an 83% positive return in 2013. In 2012, the share price lost 8%.

The steep decline over the past three months may encourage investors to enter the trade on the view that current prices may represent a good entry point, he said.

Risk

Future Value Consultants assesses the risk associated with a product by adding two risk components: market risk and credit risk. The resulting riskmap measures risk on a scale of zero to 10 with 10 as the highest level of risk possible.

The market riskmap for the notes is relatively high at 3.70. In comparison, the average market riskmap for similar products (reverse convertible category) is only 1.58, according to Future Value Consultants’ report. The difference is lower when the market riskmap is measured against the average for all products, which is 3.00.

“It’s obviously a risky product,” he said, adding that the American barrier and the stock’s volatility were the main factors.

“However, investors still have an extra 10.5% in coupon which they may use as a cushion against losses,” he said.

“It’s not impossible” that investors could lose principal “given how volatile the stock is. But volatility also plays out on the upside, which is a good thing,” he said.

The stock for instance could breach the barrier on any trading day and then recover in a wide upswing so that investors would keep their principal at maturity, he explained.

“When a stock shows wide swings on the downside, the same can also happen on the upside, so just because you breach the barrier at some point doesn’t necessarily mean you’re going to lose money,” he said.

With a credit riskmap of 0.41, pretty in line with its peers, the product received a 4.11 riskmap, a higher level than other reverse convertibles, whose average riskmap is 1.93, according to the report.

Return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets, and high- and low-volatility environments.

The return score is computed based on the best assumption, which for a reverse convertible is low volatility.

The return score is 6.30, which is below the 6.91 average for the same product type. It is also less than the all-product-type average of 7.37.

“When compared to all products, which include uncapped leveraged notes, the explanation is easy,” he said. “Investors see their upside capped by the coupon. Even though 10.5% looks like an attractive coupon, they don’t get to participate to the upside beyond that.”

On a risk-adjusted basis, the product may require additional yield to compensate investors for the risk taken, he said.

Price score

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The notes have a 7.22 price score, compared with 8.11 for the average reverse convertible.

“It’s below average. The one-year term does not help as you spread the fee over a shorter period of time. Perhaps a higher coupon or a different barrier would have helped with the score,” he said.

Overall score

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

The overall score at 6.76 is three-quarters of a point lower than the average for this product type.

“This product offers a pretty good coupon. It’s an attractive option for someone who wants more yield in less time,” he said.

“However, only investors with an aggressive risk profile should get into this because those notes are not like a traditional bond. Investors are exposed to equity risk, and their principal is at risk. The buyer of those notes would have to be relatively familiar with the stock.”

The notes (Cusip: 06741WAA8) will price Feb. 24 and settle Feb. 27.

Interest will be payable monthly.

Barclays is the agent.

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