Or: scoring an own goal.
The brief history of equity structured products – derivative-based securities – should teach buysiders one thing: quite often, they’re pure poison.
To rephrase that: structured products can quite often turn out to be traps in which the risks have been artfully concealed by the promise of high-return. The trick, from the dealers point of view, is basically to package a set of quite blatant derivative punts into a more easily identifiable “security” with comforting things like a coupon, a fixed term and a coupon that will attract the unwary.
One such structured product is the reverse convertible.
At the height of the tech boom, reverse convertibles were very very popular. The first structure, in 1998, was called the GOAL – a timely acronym since the product came to market right at the top of the World Cup fever in France. GOAL stood for Geld oder Aktien Lieferung, which means cash or share delivery.
Investors, alas, got badly burned by reverse cons when the equity bubble popped in the noughties, and since, reverse convertibles took a bit of a back seat.
Until recently anyway. On Friday, 30 reverse convertibles were brought to the market, 25 of them issued by Barclays. That on top of 10 or so the week before (6 of which were issued by Barclays).
Why the reverse convertible rush?
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Reverse convertibles are cunning structures. Ostensibly, they are a short-term bond which offers a very high coupon. Tempting.
The crucial thing with them though is that the principal on the bond is not protected. Herein, lies the risk.
In actual fact, the principal is convertible, under certain conditions, into shares of a referenced company. The conversion rate is struck when the deal closes. The sales pitch is thus that while the principal is not protected, it is exchangeable into shares in some blue chip corporation which you, dear investor, can then sell or hold as you like.
All very well, except that the conditions on a reverse convertible specify that it is the dealer who chooses whether conversion occurs, and even then, only under specific conditions.
To elucidate, it might be worth looking at the terms on one of the Barc deals. This one, for example, brought to market on Monday. Topically, it converts into United States Oil fund (ETF) shares.
A $1,000 investment in the Notes will pay $1,000 at maturity unless: (a) the final price of the linked share is lower than the initial price of the linked share; and (b) between the initial valuation date and the final valuation date, inclusive, the closing price of the linked share on any day is below the protection price.
If the conditions described in (a) and (b) are both true, at maturity you will receive, at our election, instead of the full principal amount of your Notes, either (i) the physical delivery amount (fractional shares to be paid in cash in an amount equal to the fractional shares multiplied by the final price), or (ii) a cash amount equal to the principal amount you invested reduced by the percentage decrease in the price of the linked share.
Here’s how it works:
The investor gets a short term bond that pays a high coupon. In this case, 11 per cent. Obviously in the current market that’s extremely tempting. At the time the deal is struck, an “initial price” is also set for the linked-share, in this case USO, based on its current market price. At maturity, the investor is faced with two scenarios: either, they get their principal back in cash, or they get their principal back in linked-shares. The catch is that the conversion rate for getting principal back in linked shares is also struck at the onset of the deal. If the linked-shares have fallen in price, in other words, the investor gets shares which are now worth considerably less than their principal. The investor is effectively writing a put option.
The sop to this rather bald punt is the seductive condition (b). Set out in the quoted pars above, condition (b) stipulates that the dealer can only convert the principal into shares at maturity (assuming the linked-shares have declined in value, making such an action attractive) if the linked share price has at some point during the length of the transaction breached the “protection price”.
In the Barc transaction linked to above, the protection price is set at 50 per cent of the initial price: the condition is breached if the value of USO shares falls by 50 per cent from the “initial price” at any point in the next 6 months.
In other reverse convertible deals launched recently, the protection price has been even higher, at 80 per cent of the intial price.
To summarise all of this, Barc provide this soothing table (click to enlarge):
We’ve highlighted in green the scenarios under which the note performs as promised, and those in red where it doesn’t. The invidious inference here being the inclusion of the final column – “direct investment in the linked shares”, which apparently illustrates that no matter what scenario, you’ll do better than the underlying reference security. If, that is, the linked-share price falls. (Investors don’t get to participate in the upside of the USO share price.) And indeed, even the downside “protection” wholly relies on the sneaky condition (b) not being met. If the “protection price” in condition (b) is breached, then the table shows the Barc product for what it is: an investment in USO shares whereby in exchange for an upside return capped at 5.5 per cent, a paltry 5.5 per cent buffer is provided on the downside risk.
And what is the likelihood that the condition (b) protection price is breached? A 50 per cent fall from the strike “initial price” seems like a large amount, until you look at the implied volatility of the underlying USO shares. Fortunately, the Chicago Board of Exchange has its very own volatility index based on options on the USO – the OVX.
Today’s implied 30-day volatility on the USO? 75 per cent.
In other words, the chance of the protection level being breached over the course of the next 6 months is actually quite high. And of course, if the volatility works to the upside, and the USO share price rises, then the dealer gets all the benefit anyway (they’ll opt to pay back principal, not shares).
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For dealers like Barclays, reverse convertibles are great ways of derisking their books. They are basically structured into which unattractive derivatives can be packaged. In the case of USO shares too, as FT Alphaville earlier speculated, Barclays, JPM, MS et al, may have many reasons to try and buy lots of USO shares and need to hedge its position on them.
We’re curious as to who is buying these reverse cons though.
And we’re also wary of what happened after the tech bubble collapsed. GOAL and its first generation revcon brethren lost investors a lot of money. Retail investors too. Lawsuits ensued for many different structured equity products. Inevitably when the market turns such structures make good targets for lawyers.
What may well make reverse convertibles particularly prone to such legal claims once more this time – assuming that investors get burned – is the fact that the structures are very clearly built first and foremost for the benefit of the dealer, not the client.
Related Link:
The United States Oil Fund mystery – FT Alphaville