High volatility, sell-off spur issuance of reverse convertibles tied to oil stocks

By Emma Trincal

New York, June 4 - With the increased volatility seen over the past few weeks in the oil sector, issuers have been readying or pricing more reverse convertible notes linked to the share prices of oil companies, according to data compiled by Prospect News.

The combination of rising volatility and falling stock prices is usually a good indication that reverse convertible notes may offer attractive terms and opportunities, said Tim Mortimer, managing director at Future Value Consultants.

Volatility surge

When volatility is up, issuers can sell options at a higher premium and, as a result, are able to offer better terms and more attractive coupons to investors, he said.

"Oil stocks volatility has picked up recently, and it's a natural consequence of the BP [plc] disaster," said Brad Zigler, research analyst at Hard Assets Investor.

"If you measure volatility since the April 22 rig collapse, the energy market has vacillated at a 38% annualized rate while oil and gas stocks slid 13.1%," Zigler said.

Large deals

Some of the biggest deals last month exceeded the $10 million mark.

Citigroup Funding Inc. priced $17.51 million of 13% annualized Equity LinKed Securities due Nov. 24, 2010 linked to the common stock of Halliburton Co.

Deutsche Bank AG, London Branch priced $11.32 million of 14.5% annualized yield optimization notes with contingent protection due Nov. 22, 2010 linked to the common stock of Schlumberger Ltd.

Timing the bottom

The sell-off of oil company stocks is also attractive for reverse convertible investors seeking high income, sources said.

When stocks fall sharply, risk-taking investors bet that they will go up. They are also hoping to capture volatility at its peak while they're selling it and that it will decline over the term of the notes, with the assumption that volatility was overpriced to begin with, said Mortimer. As volatility declines looking forward, the chances of breaching the barrier are slimmer, he said.

"There's been more reverse convertible deals in the market lately," Keith Styrcula, chairman of the Structured Products Association, told Prospect News.

"With the gusher still underneath in the Gulf, you'll see a real shift in the oil industry. People are wondering whether drilling offshore will be affected by regulatory changes or whether BP is going to lose all of its business and go under. It's an unbelievable catastrophe, and it has magnified volatility of oil stocks."

'Eye-popping yields'

Styrcula added that the spike in volatility was "a little bit of a concern" as "people are chasing eye-popping yields without always understanding what's going on in the sector."

Issuers have indeed been able to increase yields.

For instance, Royal Bank of Scotland NV recently priced $2.35 million of 35% annualized Knock-In Reverse Exchangeable Securities due Aug. 31, 2010 linked to ATP Oil & Gas Corp. shares.

Three Barclays

Barclays Bank plc - an issuer that usually prices smaller-sized reverse convertible offerings, according to data compiled by Prospect News - brought to market three $10 million deals last month, all linked to oil stocks.

The underlying stocks were Baker Hughes Inc., Cliffs Natural Resources Inc. and Suncor Energy Inc.

Other deals

Autocallable notes also benefit from volatility spikes, a sellsider said. As a result, one issuer priced a deal of nearly $10 million linked to an energy exchange-traded fund.

HSBC USA Inc. priced $9.62 million of 0% autocallable optimization securities with contingent protection due June 1, 2011 linked to the Energy Select Sector SPDR fund. UBS Financial Services Inc. and HSBC Securities (USA) Inc. were the underwriters.

On a smaller scale, JPMorgan Chase & Co. priced $4.13 million of 14.12% yield optimization notes with contingent protection due May 31, 2011 linked to the common stock of Plains Exploration & Production Co.

In other deals, Barclays priced reverse convertibles tied to ConocoPhillips shares, and JPMorgan priced reverse exchangeable notes linked to the common stock of Walter Energy Inc.

More deals are expected to price in the upcoming week, such as Citigroup's 8% to 12% annualized Equity LinKed Securities due Dec. 22, 2010 linked to Chevron Corp., set to price on Thursday.

Owning equity

Investors in reverse convertibles earn their coupon regardless of the performance of the underlying stock, according to most issuers' prospectuses.

Those documents often stress the two main risks for investors.

First, if the underlying stock ends lower than the knock-out level, investors receive an amount of shares at maturity that could be worth less than their principal.

The second risk is that the coupon would be less than the growth of the underlying share price, as investors in the notes do not participate in the stock performance.

For some investors looking to get equity exposure to the oil sector, investing in reverse convertibles may offer a value investing opportunity, as some predict that the sell-off in the sector may be near its bottom.

"What I like about reverse convertibles is that even if your stock declines below the threshold, you actually own shares. You own the stock. Your downside risk is that you're getting the stock. It's not the worse thing in the world. A least you can play these things intelligently," said Marc Gerstein, research consultant at Portfolio123.

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