Low rates offset gain from higher volatility, analyst says; Barclays plans unusual bear note

By Kenneth Lim

Boston, Aug. 7 - Higher underlying volatility should mean that more attractive terms for structured product investors, but that has not been the case because of an exceptional drop in interest rates, said structured products analyst Tim Mortimer of Future Value Consultants.

JPMorgan Chase & Co. plans to price a series of Return Optimization Securities due Feb. 28, 2011 linked to the S&P 500 index.

At maturity, investors will receive par plus double any gain in the index, subject to a maximum total payout of 117% to 120% of the principal. If the index is flat or declines by no more than 10%, investors will receive par. Investors will lose 1% for every 1% that the index declines beyond 10%.

The exact cap will be set at pricing.

JPMorgan in April 2008 priced a similar product that matures on Oct. 30, 2009. The older product also had a 1.5-year tenor, a 200% upside participation rate and a 10% buffer. The cap was set at 119% of the principal.

Cost of volatility

The volatility of the S&P 500 has increased considerably since the older note was issued. Back in 2008, annualized underlying volatility was about 20%, according to Future Value's research reports. The newer product has an underlying volatility of about 43%.

"It's certainly true that the volatility has gone up in that time, although at the moment the implied volatility isn't very high for pricing purposes," Mortimer said.

Higher volatility in the index means that investors are more likely to exceed the buffer on the downside and hit the cap on the upside, he explained.

"If just the volatility had gone up, then it would be more likely you would see maybe a higher cap," he said.

But what happened over the past year was that interest rates also fell sharply in response to the economic crisis.

"In a structured product you swap the interest for cash or for upside at the cost of some risk," Mortimer said. "But when the interest rate goes down, there's less interest in the swap."

The steep drop in interest rates has affected all structured products, not just accelerated notes, he added.

"That makes virtually every structured product more expensive because of less discounting," Mortimer said.

The good news for investors is that current interest rates are about as low as they can go, so if the volatility of the markets pick up again, new products will likely come with better terms. And what has happened over the past year is not typical, Mortimer noted.

"We're in exceptional times when the normal rules don't seem to apply to anything," he said.

Strong view

A Barclays Bank plc one-month bear note linked to the common stock of Louisiana-Pacific Corp. is essentially a short position on the underlying with a buy-stop level at 200% of the initial price, Mortimer said.

The planned Barclays note will pay par minus the stock return at maturity, subject to a floor of zero.

"If you've got a very strong view on the stock, and I haven't done any research on the stock, it's kind of a fairly simple play," he said.

The most that investors can get is double the principal, because the stock cannot fall by more than 100%, and the most that they can lose is 100%. Barclays could make a little on the product on the front end, Mortimer said.

"There's a slight cost of carry effect in their favor," he said.

The unusual product is likely the result of a specific reverse inquiry, Mortimer said.

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