Barclays' planned 12% callable reverse convertibles on General Electric add yield, uncertainty

By Emma Trincal

New York, May 20 - Barclays Bank plc's upcoming 12% annualized callable reverse convertible notes linked to General Electric Co. shares may appeal to neutral investors who seek to enhance yields by accepting the uncertainty of a potential early redemption scenario, sources said.

"This is a product for income-seekers that pays a high coupon," said a market participant. "But part of it is because of the call provision."

The notes will mature Nov. 26, 2010, according to an FWP filing with the Securities and Exchange Commission.

Interest is payable monthly.

The notes will be called at par if General Electric stock closes at or above the initial share price on July 21 or Sept. 22.

The payout at maturity will be par in cash unless the price of General Electric stock falls below the protection level - 70% of the initial level - during the life of the notes and finishes below the initial price, in which case the payout will be a number of General Electric shares equal to $1,000 principal amount divided by the initial share price.

Neutral on GE

"You don't have to be very bullish at all in order to buy the notes. You have to believe that you'll do better in six months at 6% than you would in investing in the stock itself," said the market participant.

"You can also be bearish but moderately bearish. Your view is that the stock could fall but not by more than 30% in six months," this market participant added.

Tough call

However, a financial adviser said that he was not comfortable with the callable nature of the product and the process by which the call is triggered.

"We've seen callable reverse convertibles before. But we don't play in this arena. It's just impossible to predict what the stock will do on July 21 or Sept. 22. It's almost a gamble. How can you allocate that to a client's portfolio? There's too much uncertainty in it. We are in the asset-allocation business, and so I guess this would not be for us," the adviser said.

Yield enhancer

But for others, the call feature is the trade-off that gives investors a chance to lock in an even higher yield than with a bullet reverse convertible.

"It's an autocallable. The investor is indifferent whether he gets 6% in six months or 2% in two months. It's the same coupon," said the market participant.

"The interesting piece here is that the call is precisely what allows the issuer to give investors a higher coupon. The bank gets the flexibility to manage its exposure a little bit better because if things go against their hedge, they can unwind the trade. And the investor gets a higher yield," he noted.

"For the issuer, the cost of a callable option is going to be cheaper than the cost of a plain-vanilla option. So that's what gives them the ability to offer better terms," he said.

Reinvestment risk

However, the potential early redemption brings another type of risk for the investor, said Suzi Hampson, structured products analyst at Future Value Consultants.

"If the stock is up after just two months, there is less chance for the barrier to be breached on the remaining term because you only have less time left to breach the same 30% barrier," said Hampson.

"So the investor, at that point, would have been better off to stay in. Once his notes are called, he may not be able to get the equivalent rate or better," Hampson said.

Reinvestment risk, or the odds of not earning the same coupon or return after a note is redeemed early or matures because interest rates have changed, is "a possibility," said the market participant.

"But you're always going to get reinvestment risk on an autocallable. The price the issuer compensates you for the uncertainty of not knowing when you'll get your money back is the higher coupon. But if there is a call, the investor may not be able to invest at the same rate or better. That's the trade-off," he said.

Negative convexity

Callable notes also offered the risk of negative convexity, this market participant said. "As yields decrease, duration decreases too," he said.

But he said that the higher coupon offsets this drawback and that the short term duration of the notes made negative convexity almost irrelevant.

"Callable notes or bonds are very popular across all fixed-income categories. Fannie and Freddie ... and FHLB are huge issuers of callable bonds. That's simply because callable paper provides issuers with some flexibility and enhances returns for the buyer," this market participant said.

He said that negative convexity was one of the inconveniences of callable securities.

"However, with a six-month product like this one, the impact of negative convexity is not significant," he added.

Collar-like

Investors in the notes will likely be neutral on the stock as they do not see sharp moves up or down during the term.

The stock price is up 7.5% year-to-date.

"As an investor, it's almost as if I was buying a collar. There's no upside if it goes up. And there is a limited downside protection of 30%," he said.

A collar is an option strategy in which an investor limits his downside via the sale of a call option on the stock. With some of the premium, he buys a put in order to limit the downside to a certain amount, which here would be the 30% barrier, the market participant explained.

The notes were scheduled to price May 20 and settle May 25.

Barclays Capital Inc. is the agent.

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