Two Barclays reverse convertible notes linked to tech stocks give risky exposure to sector

By Emma Trincal

New York, Jan. 15 - Investors in the technology sector with a strong tolerance for risk and seeking a rewarding income may consider a reverse convertible note, said structured products analyst Suzi Hampson at Future Value Consultants. But they have to be prepared for the downside, she noted.

"A lot of times, reverse convertibles compared to growth products are risky," said Hampson. "You have to be willing to invest in one stock. It's very volatile. And while the short-term horizon may appeal to many, you have to be an investor willing to take quite a considerable amount of risk."

Hampson picked two examples of six-month reverse convertibles tied to a technology stock.

Set to be priced Jan. 26, both deals were announced by Barclays Bank plc in a recent FWP filing with the Securities and Exchange Commission.

Two reverse convertibles

Barclays said it plans to price 10% reverse convertibles due July 29, 2010 linked to the common stock of mobile communications company Motorola Inc. The payout at maturity will be par in cash unless Motorola shares fall below the barrier - 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 Motorola shares equal to $1,000 divided by the initial share price.

Barclays also announced 20% reverse convertibles due July 29, 2010 linked to the stock price of Rambus Inc., a chip interface technologies developer. The payout at maturity will be par in cash unless Rambus shares fall below the protection price - 55% 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 Rambus shares equal to $1,000 divided by the initial share price.

Volatility dictates terms

The main distinction between those two transactions lies in the stocks and each stock's respective volatility, said Hampson. In addition, the structures are "quite distinct," she noted, with the Rambus-linked reverse convertibles offering a much lower barrier of 55% and a coupon twice as high as that of the other deal.

The maturity and the issuer, hence the credit risk, are the same, she added.

"But you can't compare two barriers when the underlying stocks have different historical volatilities," said Hampson. "If it was the same stock, you could say that 55% is better than 75%."

Historical volatility is the measure of the volatility of the underlying stock. In its reports, Future Value Consultants uses the term "underlying volatility."

Hampson compared the underlying volatility for both stocks: 96.96% for Rambus versus 72.50% for Motorola.

"This difference in volatility allows the issuer to give you better terms with the note tied to the most volatile stock," Hampson said, referring to the Rambus structure. "You get twice the coupon and a lower barrier. If you think of those deals being priced on your risk of losing your principal when you breach the barrier, it's clear that the more volatile the stock, the more likely you are to breach the barrier."

Implied and historical

Based on this reasoning, the two products should be characterized by very different levels of risk, said Hampson. But this is not the case, she noted, pointing to each product's riskmap, Future Value Consultants' rating that measures the risk associated with a product on a scale of zero to 10.

The reverse convertibles linked to Rambus have a 7.86 riskmap. It is 7.76 for the Motorola deal.

"This is fairly similar," said Hampson, who offered two explanations for the lack of difference in risk despite the fact that one stock is more volatile than the other.

The first explanation is the difference in barriers.

"While Rambus has a higher underlying volatility, it also has a more protective barrier. So one offsets the other to some extent," she said.

The second explanation is the methodology employed by Future Value Consultants when calculating its ratings.

"While we use implied volatility for the pricing, at the moment, we calculate return and riskmap based on the underlying volatility. It's been a better model when we worked with indexes, but it doesn't work as well with stocks. We'll be changing that at some point," she said.

The firm does not publish implied volatility figures in its reports. But Hampson said, "You're looking at something in the 80's for Rambus against the higher 30's for Motorola. It's quite a gap."

And while the two different underlying volatilities differ sharply (96.96% versus 72.50%), the gap is much greater when comparing the two different implied volatilities, she added.

As a result, the riskmap associated with the Rambus deal would have been much higher if the firm had used the implied volatility calculation of risk and returns rather than using the historical volatility, she said.

Return ratings

Return ratings for the products are also "fairly similar," said Hampson, adding that the reason is essentially the same since the firm at this point continues to use underlying volatility for the calculation of the returns.

Return rating is Future Value Consultants' indicator, on a scale of zero to 10, of the risk-adjusted return of the notes.

For the Rambus notes, this rating is 2.57, slightly higher than the 2.25 score for the Motorola reverse convertibles.

To broaden her return analysis, Hampson looked at the probability tables of returns published in the report. Investors in the reverse convertibles linked to Rambus shares had a 44.2% probability of losing more than 5% of their capital. The odds were 43.6% for the investors in the other product.

"For the return, we don't just look at the probability of scoring a certain percentage of losses," said Hampson. "We also take into account how much capital you are likely to lose."

She said that the notes linked to Rambus, the more volatile underlying, are those where investors are the most likely to lose the most.

Value matters

Hampson concluded her comparative analysis by noting a significant difference between the two structures' respective overall ratings.

The overall rating, on a scale of zero to 10, is Future Value Consultants' opinion on the quality of a deal, taking into account costs, structure and risk-return profile.

According to Future Value Consultants, the overall rating for the notes tied to the Rambus stock is 2.82. For the structure linked to Motorola shares, the score is 5.14.

"They're both quite low. But since risk ratings and return ratings are fairly similar between the two deals, it's the value rating that makes the difference here," Hampson said.

Value rating, one of the components of the overall rating, is a rating on a scale of zero to 10 that measures 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. Rambus' value rating is 0.23 while it is 6.36 for the Motorola structure.

"This suggests that the issuer spent more money structuring the product and buying the assets with the Motorola transaction. As a result, the structure offers a much better value to investors," Hampson said.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.