JPMorgan's 16% reverse convertibles on Silver Wheaton offer good barrier, but risk remains

By Emma Trincal

New York, March 11 - JPMorgan Chase & Co.'s upcoming issuance of 16% reverse convertible notes due Sept. 30, 2011 linked to Silver Wheaton Corp. shares offer a good barrier given the highly volatile underlying stock, enabling the issuer to somehow reduce the risk of the product, said Suzi Hampson, structured products analyst at Future Value Consultants. However, given the volatility of the underlying stock, the product should only target aggressive investors.

The payout at maturity will be par in cash unless Silver Wheaton shares fall below 75% of the initial price during the life of the notes and finish below the initial price, in which case the payout will be a number of Silver Wheaton shares equal to $1,000 divided by the initial price, according to an FWP filing with the Securities and Exchange Commission.

"The very high coupon indicates obviously that there is risk involved, so this is really a product for rather aggressive investors, as most reverse convertibles are," she said.

While a 25% level of protection is "quite decent" for these types of structures, it only reflects the high level of volatility of Silver Wheaton shares, she said, which has a 51% historical volatility and an even greater implied volatility of 60%.

Barrier and volatility

"The 75% barrier means that the stock needs to decline by 25% before a loss may occur. It seems like a lot. But with that type of volatility, it's definitely possible," she said.

"In order to make the product valuable, the issuer had to offer a generous barrier, otherwise it's not worth it. So it reduces the risk. But there's still risk.

The risk, as measured by riskmap - a Future Value Consultants' rating on a scale from zero to 10, is 4.44.

"It doesn't look too bad. It's average. We've definitely seen products that are riskier than that," she said. "You have a good barrier, and it has some impact on the risk profile."

Value 'very low'

And yet, Hampson said that "the product is not priced well," as illustrated by a "very low" value rating of 0.70 on a scale of zero to 10.

This score, put together by Future Value Consultants, represents the real value to the investor after deducting the costs the issuer charges in fees and commissions on an annualized basis.

"Given the high volatility of the stock, we didn't think the options they bought were worth a lot. They probably could have offered either a higher coupon or a lower barrier," she said.

Risk adjusted return

However the risk-adjusted return is still attractive, she noted, pointing to a 4.15 return score, which she said was above the average.

The return score, also based on a zero to 10 scale, is Future Value Consultants' measure of the risk-adjusted return for all recently rated products in all structure types.

According to the probability table of return outcomes, investors in this note have two chances out of three of scoring the maximum return of 16% and only a probability of one third to incur a loss of more than 5% of their principal.

"You have quite good probabilities of getting the 16% coupon," she said.

If on the other hand, the barrier is breached, the likelihood of losing at least 25% is greater, she explained. That's because the six-month tenor is too short to give the stock enough time to recover.

"The worry would be for investors to get into this deal for the high coupon only. It's the broker's responsibility to make sure that the investor understands the risk clearly," she said.

"You'll never see a reverse convertible that is not risky," she said. "This is why the investor should really have a view on the stock before buying this product."

Overall rating

The overall rating, on a scale of zero to 10, is Future Value Consultants' opinion on the quality of a deal. It's an average of three scores weighted 40% to the value score, 40% to the return score and 20% to the simplicity score.

This product received a 3.65 overall rating.

"It's not a high overall score. It's been pulled down by the very low value score," said Hampson.

The notes are expected to price on March 28 and settle on March 31.

JPMorgan is the agent.

The Cusip is 48125XHW9.

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