Reverse convertible linked to Las Vegas Sands stock are risky bet on volatility, analyst says

By Emma Trincal

New York, Sept. 25 - Three recent new issues of reverse convertible notes linked to Las Vegas Sands Corp. stock, while slightly different in structure, have in common an unusual level of risk, said structured products analyst Suzi Hampson of Future Value Consultants. Las Vegas Sands is a casino operator and resort company, whose stock price has risen by 198% year to date.

"Anyone investing in these notes would have to be prepared for losses," Hampson said. "These are some of the riskiest products we have."

ABN Amro #1 and #2

Two deals were offered by ABN Amro NV and priced in the past two weeks. Another one offered by UBS AG was set to price Friday.

On Sept. 14, ABN Amro priced $0.52 million of 11.5% knock-in reverse exchangeable notes due Dec. 17, 2009 linked to Las Vegas Sands stock. The principal amount is not protected at maturity if a 55% barrier is breached and the stock finishes below its initial level. There is no upside participation if the stock goes up as the entire return is the 11.5% coupon.

About a week later, on Sept. 22, the same issuer priced $0.25 million of a very similar structure featuring the same 55% barrier, but with a 15.2% coupon and maturing Dec. 24, 2009.

Asked about why the second deal with a higher coupon sold less notes, Hampson commented: "Same barrier, same maturity, same underlying; the only difference between the two is one week. It's hard to comment on sales. I guess people had already bought the first one the week before."

The difference in returns was reflected in the difference in overall ratings, said Hampson.

The notes with the 15.2% coupon and those with the 11.5% coupon have an overall rating from Future Value of 4.30 and 3.98 respectively. The overall rating, on a scale of zero to 10, is Future Value's opinion on the quality of a deal, taking into account costs, structure and risk-return profile.

On the other hand, both offerings have an equivalent riskmap - Future Value's rating on a scale from zero to 10 of the risk associated with a product.

"You have the same riskmap because it's the same barrier and the same stock," said Hampson. For both deals, the riskmap is approximately 4.

UBS too

On Friday, UBS AG was to price reverse convertibles due Dec 30, 2009 with the same underlying stock.

The main difference, besides the issuer, was a higher coupon of 26.25% and a higher barrier of 60%. Pricing levels were not available at press time.

"This one has the largest coupon because there is less protection with the higher barrier," Hampson said.

She noted that Las Vegas Sands is an extremely volatile stock, with an annualized volatility of about 100%.

"The stock has moved so much that it makes sense for some to bet it is not going to move that much in the future. The coupon is extremely high but to break the barrier at 60% is still doable, so there's plenty of risk. It helps that the deals are short-term. In one year, you would have more risk to break the barrier. I guess three months is worth the risk for a lot of people," she said.

The UBS structure has a riskmap of 5.86.

"There's more risk here because of the barrier," she said.

However, the deal as a whole rates better than the others, she said.

The overall rating for the UBS deal is 5.29. It is higher than the two other structures because of a higher value rating, one of the components of the overall rating, she explained.

The value rating on a scale of zero to 10 is Future Value's measure of how much money the issuer spent directly on the assets versus other transaction costs such as direct fees and profit margin on the underlying derivative.

From the investors' standpoint, the higher the value rating is the better. The two ABN Amro deals had value ratings of approximately 4 while UBS scored 7.21.

Volatility play

Hampson said that a comparison between the historical volatility and the implied volatility of Las Vegas Sands' stock can explain why the use of reverse convertible notes would make sense here.

The historical volatility of the stock is around 100%, on an annualized basis, she said. "That's quite high."

Historical volatility measures the realized volatility over a period of time. It is often calculated using standard deviation, or the average deviation in price from the average price of the stock.

Hampson noted that by contrast, the implied volatility of the Las Vegas Sands stock tends to be lower than its historical volatility. Implied volatility measures how the market perceives volatility and is calculated based on an analysis of the option and futures trading on the stock today.

"It seems that the implied volatility is slightly decreasing," Hampson said. "That would mean that the stock is going to be less volatile in the future than it has been in the past. Such a scenario makes for an attractive stock for reverse convertible," she said.

The reason behind that, she said, is due to how reverse convertible compensate investors. Investors get all their return in the coupon, not from the appreciation of the stock.

"As long as the stock doesn't breach the barrier, it doesn't matter which way it moves, up or down. All you need is for the stock not to move that much," she said.

This is why it is better for investors to buy reverse convertible notes referencing a stock that has been highly volatile but whose volatility may lessen in the future, Hampson explained.

Such behavior is indicated when the historical volatility scores higher than the implied volatility.

"If something has a high volatility now, it's better for you. You could get good terms and a lower barrier. Say your deal prices when the volatility is very high but later on, it declines. Your notes would be worth much more," she said.

Hampson concluded that investors in those notes show a strong appetite for risk and that they are making volatility bets. If the stock falls beyond the barrier, an investor in the notes would lose as much as a direct investor in the stock, she said.

The only difference is the added protection when the stock does not breach the barrier, she said. "This is why those investors are volatility players. They hope that in the short run the stock will not fall by that much."

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