Investor stands to profit more from put sale than Barclays' 10.25% notes linked to Baidu

By Emma Trincal

New York, Aug. 5 - Barclays Bank plc's upcoming 10.25% reverse convertible notes due Feb. 29, 2012 linked to Baidu, Inc. American Depositary Shares may not offer as attractive a risk-return profile as an equivalent put-selling strategy, said Ryan Detrick, senior equity analyst at Schaeffer's Investment Research.

The payout at maturity for the product will be par in cash unless Baidu 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 Baidu shares equal to $1,000 divided by the initial price, according to an FWP filing with the Securities and Exchange Commission.

The notes are expected to price on Aug. 26.

"Baidu is a very actively traded name. People are familiar with it. It's usually referred to as the Chinese Google. We like it. It has a nice liquidity," said Detrick.

$115 support

Based on his technical analysis, Detrick determined the support level for the stock, a price level below which the stock is not expected to fall given historical patterns.

Detrick said that "a pretty solid support" would be $115, which is 18.5% less than Friday's close of $141 (Nasdaq: BIDU).

"It fell to that level twice this year, in February and June. I wouldn't expect it to breach that threshold," said Detrick.

In comparison, the 75% barrier embedded in the notes presents a higher level of protection with a 25% cushion that corresponds to a $106 strike price, he noted.

"There are still three weeks to go before pricing, and with this market, things can change rapidly," he said.

"Just look at today. The market ended flat on Friday, closing a highly volatile week, the worse since the 2008 financial crisis.

"But I see the $115 level as a strong support. So I wouldn't really trade more protection for less premium, which is what you have here."

Shorting puts

The notes replicate a put-selling strategy with a $106 strike price, Detrick said.

"The investor sells a put and collects a premium for the risk of the stock falling and hitting the strike," he said.

The premium collected by a put seller is the equivalent of the coupon of 10.25% per year received by the noteholder, or 5.12% for the term.

"You keep the premium regardless of what happens to the stock," he said.

The seller of a put has to buy the stock at the strike price.

If the stock price falls below the strike, investors will incur a loss when forced to buy the shares at a higher price.

"As long as the stock doesn't fall below the strike, the investor is in the money and gets his principal back at maturity," said Detrick.

Replicating with options

Detrick said that there are no listed put options with a February expiration date.

"The closest is January, a five-month term," he said.

Nevertheless, he compared the two strategies, one consisting of buying the notes and the other of selling a put on the underlying stock.

Based on a stock price of $143.98 pulled from his screen, Detrick said that a put contract with a January expiration date and a strike of $105 would give a return on margin of 36.36%.

In comparison, the coupon paid on the six-month reverse convertibles is 5.12%, or 10.25% per annum.

"You can see the difference in payout, and you're not even talking six months, but five," he said.

"The longer the term of your contract, the more premium you should collect as one more month adds more risk. But here you're getting less for a longer duration."

The level of protection from the original price of $143.98 to the $105 strike would be 27%, which even adds 2% of extra protection compared to the notes, he added.

Extra support

Detrick said that the notes may even be offering more protection than necessary not just because he estimated the support of $115 to be higher than the downside threshold of $106 but also due to the popularity of the name among sophisticated investors.

"Baidu is heavily traded by hedge funds, and they would defend it in a pullback.

"So you're already sacrificing too much upside to give yourself some extra room of support that you may not even need.

"Even all things being equal, you're getting better compensated with the put than with the notes for the same amount of risk.

"If you're optimistic about Baidu, it makes more sense to sell significantly out-of-the money puts at this time and collect more premium.

"In this particular case, the put-selling strategy offers a better risk/reward than the reverse convertible notes."

Barclays Capital Inc. is the agent.

The Cusip number is 06741JLW7.

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