Barclays' 20% reverse convertibles linked to Stillwater Mining rank high in risk, volatility

By Emma Trincal

New York, May 7 - Barclays Bank plc's upcoming 20% reverse convertible notes due Aug. 30, 2010 linked to Stillwater Mining Co. shares are for short-term investors wanting a high coupon but willing to take on a more-than-average level of risk, said structured products analyst Suzi Hampson at Future Value Consultants.

The payout at maturity will be par in cash unless Stillwater Mining shares fall below 80% 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 Stillwater Mining shares equal to $1,000 divided by the initial price.

This product offers a high income of 20% per year that will be paid at maturity regardless of the performance of the underlying stock, said Hampson.

"This is one of the main differences between reverse convertibles and other structures such as growth products, for instance," she said.

"This is for very short-term investors, seeking high income and willing to take on a great deal of risk," added Hampson.

"A 20% coupon is high, and it's the result of the highly volatile underlying stock. The short maturity also helps boost the coupon a little. You tend to get higher coupons on very short maturities," she said.

Think equity

Hampson said that investors looking for a reverse convertible product should not choose the product based on the coupon only.

"You're looking for income. You also want to minimize loss of principal, relying on the movements of a stock. You must have some good reasons to choose that particular underlying and not another. The high coupon should not be the decisive factor," she said.

Hampson also noted that the risk associated with reverse convertibles is very similar to the risk involved with stocks.

She stressed some differences between the two types of securities.

First, a reverse convertible will always pay a coupon that is not dependent on the stock performance, she said.

Second, the reverse convertible structure offers partial protection on the downside with the buffer, which obviously the stock does not offer.

"But it's still a very similar type of risk. So you should take the same care in researching your underlying than researching a stock," Hampson noted.

High implied

The Barclays 20% reverse convertibles linked to Stillwater Mining are riskier than most other reverse convertible products, said Hampson. One key reason for that, she said, is the high level of volatility seen in the stock.

Stillwater Mining stock has an 85% historical volatility, which measures the realized volatility of the stock over a past period of time.

The implied volatility, or the expectation the market has for future volatility levels, is 70%.

"A 70% implied volatility is quite high," said Hampson.

The implied volatility, as it is used to price the options, will also determine the pricing of the notes, she said.

A higher implied volatility generally would give more leeway for a higher coupon, she noted.

Volatility expectations

Reviewing her analysis of the underlying stock, Hampson said that the historical volatility was greater than the implied volatility, which is desirable for investors.

"If the implied is lower than the historical volatility, you might read that as a sign that the implied is falling. If that's the case, the chances of breaching the barrier looking forward are reduced, and that's exactly what you want as an investor," she said.

Another benefit of having a lower implied volatility compared to the historical volatility, she said, is for secondary market trading.

"If you're considering selling your security on the secondary market, it could be interesting. As volatility decreases, the value of your investment increases as well," she said.

In general, she noted, investors in a reverse convertible product are short volatility. Their view is that implied volatility is going to decrease.

High risk

Since the high implied volatility means more risk, riskmap, Future Value Consultants' rating that measures the risk associated with a product on a scale from zero to 10, was higher than usual at 8.04.

"The stock is very volatile. The 20% barrier looks like a lot, but with that type of volatility, it's actually rather thin," said Hampson.

A high level of risk will decrease the return rating, which measures on a scale of zero to 10 the risk-adjusted return of the notes.

Future Value Consultants calculates the return score from a Monte Carlo simulation, which it also uses to determine its probability table of return outcomes.

Low return score

Return rating for these notes is only 1.31 because "your chances of losing capital are high," she said.

The probability of making more than 15% was 49.1%.

The odds of losing more than 5% of principal were 48.5%.

"Return rating is low because of the high probability of losing some of your principal. It's a fifty-fifty chance to either lose some capital or to earn more than 15%. It's not particularly good," she said.

Hampson added that the chances of breaking the barrier were "high" and that investors were likely to incur heavy losses if the stock fell by 20% or more.

Big picture

"This product has a low return rating and a high riskmap. If you look at the [rating versus riskmap] chart, the riskmap is much higher than most other recently rated products. It's the worse place to be, and that's why we haven't given it a good overall rating," said Hampson.

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. It's an average of three scores weighted 40% to the value score, 40% to the return score and 20% to the simplicity score.

The overall rating is only 2.50 for this product.

Simplicity at 8.50 was high because the structure is simple to explain and understand, Hampson said.

Value rating, which measures on a scale of zero to 10 how much money the issuer spent directly on the assets, was very low at 0.68.

"This value score could change. It could be partly due to the fact that the product has not priced. We're dealing with indicative terms at this time. The short duration could play a role too in lowering the score given that you have some fixed costs making longer-duration deals relatively cheaper," she said.

The low return rating contributed to a large degree to the low overall score, she said.

The notes are expected to price on May 25 and settle on May 28.

Barclays Capital Inc. is the agent.

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