RBC's reverse convertibles linked to Patriot Coal repriced with less premium, more protection

By Emma Trincal

New York, March 22 - Royal Bank of Canada's upcoming19.25% reverse convertible notes due June 30, 2011 linked to Patriot Coal Corp. shares offer a lower premium but a bigger buffer than a similar deal priced last week.

The issuer has been adjusting prices based on wild volatility swings, sources said.

The notes offer a 75% barrier, or 25% protection, according to an FWP filing with the Securities and Exchange Commission. It means that investors at maturity will get par in cash unless Patriot Coal 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 Patriot Coal shares equal to $1,000 divided by the initial price.

On March 15, a similar deal from RBC priced for $402,000 with a 27.95% coupon but a smaller buffer of 20%. This deal initially was set to price with a 21.95% coupon, according to a preliminary term sheet filed with the SEC on March 4.

"They lowered the rate and raised the buffer. It could be a marketing situation. Maybe they sold so much of it they didn't think they needed to offer such a high coupon. Or it could be that some people want more downside protection, and lowering the coupon is the price for expanding the buffer," a market participant said.

Volatility factor

Thomas Livingston, director of structured products at Halliday Financial Group, explained that structurers are able to offer higher coupons when volatility spikes because reverse convertibles are short volatility. Inversely, a decline in volatility can limit the amount of the premium offered to the investor.

"When you structure a reverse convertible, you basically sell some calls. I've seen repricing of reverse convertibles - but from 28% to 19% in one week, we haven't seen that in a long time. It's not unprecedented, though. We've seen that before, back in 2009," Livingston said.

"You eat up your premium when you buy the protection and also when you pay out the commission," he added.

"They gave more protection, so that's one thing. In general, the coupon can also go down when you pay more in commission. If your deal is done for a fee-only account, there's no commission and you can pay a higher coupon. But if it's a retail deal and you have to pay a commission to the broker, it eats up your premium."

Raising the coupon

Livingston said that he sees more deals being repriced with a higher coupon than the opposite.

"I've seen coupons being repriced lately. Not so much down than up because when volatility picks up, you get a big premium," he said.

Volatility as measured by the CBOE Volatility index, or VIX, has gone up and down in wild swings, sources said when talking about March, which saw an escalation of the Libyan crisis as well as the Japanese earthquake and nuclear accident.

From the beginning of the month to March 16 after the earthquake, the VIX rose 40% to nearly 30. Since then, the index has retreated to 20, down 33%.

RBC repriced many deals this month, raising coupons for the most part, noted Suzi Hampson, structured products analyst at Future Value Consultants.

For instance, in early March, RBC said it would price 18.5% reverse convertible notes due June 20, 2011 linked to ATP Oil & Gas Corp. On March 15, RBC priced $732,000 of the notes with a 24.05% coupon. The 25% buffer remained the same.

The same happened for a three-month reverse convertible deal on Delta Air Lines Inc. The coupon rose to 17.55% from 13.50% without a change in the 80% barrier.

"Reverse convertible coupons usually stay the same as indicated, but there are quite a few that went up with the final term sheet as there has been a bit of a rise in some U.S. stock volatility," Hampson said.

Sources said that the repricing of the Patriot Coal deal with a lower coupon could be explained the same way: volatility has been on the decline since last week.

But other factors are at play too, such as the fact that the lower coupon comes with a more protective barrier in the revised term sheet.

"If you compare two deals pricing on the same day, if you're going to give a bigger buffer, you'll have to offer a lower coupon," said Hampson.

An example is two deals tied to Patriot Coal, which both priced on March 15. One was RBC's $402,000 with the 27.95% coupon and the 20% buffer. The other was Barclays Bank plc's $250,000 of 14.5% reverse convertibles due June 20, 2011 with a bigger buffer of 30%.

Underlying stock, sector

Demand for the stock is also a factor, sources said.

"You get less of a risk premium on a blue chip. Patriot is not a blue chip, although it's one of the most well-known names in the coal area," Livingston said.

Patriot Coal stock closed at $23.85 on Tuesday and is up 31% over the past three months.

Some sources said that coal offers a positive outlook.

"There's a lot of talk about oil companies with what's going on in Japan. Coal is the beneficiary of the recent events. It's cheap. We have lots of it," said Livingston

"The earnings potential for some of these coal companies is pretty good. And the regulatory environment is loosening up a bit."

Sources said that coal may benefit from a shift in public opinion.

"With the recent nuclear accident in Japan, the coal situation may have changed. Public opinion has a less favorable view on nuclear power. Oil and coal should benefit from this shift," the market participant said.

Livingston said that he likes coal as a sector but that volatility in general makes him nervous when it comes to buying reverse convertibles.

"Patriot Coal is one of the most well-known names in the coal sector," he said. "With the huge swings in volatility seen in the past week or so, in this kind of environment, unless I get a really big protection, I'm not so interested in reverse convertibles - or unless it's a stock I would really want to use like [General Electric Co.] Then I wouldn't mind," he said.

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

RBC Capital Markets, LLC is the agent.

The Cusip number is 78008K2T9.

© 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.