Raffeisen Centrobank offers low-barrier reverse convertible

Raffeisen Centrobank has issued reverse convertible notes linked to the Euro Stoxx 50 Index. Fixed annual coupons are on offer, with risk to capital dependent on whether a relatively low barrier is breached

Low barrier to reduce capital risk

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This is a three-year reverse convertible note linked to the Euro Stoxx 50 Index. Investors will receive a fixed annual coupon of 5% and the amount of the capital returned at the end of the product term depends on whether the barrier has been breached.

The barrier levels of the vast majority of retail structured products in the UK are set at 50%, but this product's barrier is relatively low at 41% of the initial index level. If it is breached during the product term, investors will be 100% exposed to any decline in the underlying and the amount of capital repayment will depend on the level of the index on the final day of the investment.

The 5% coupons are paid annually regardless of the underlying, so even if there is some loss to capital investors could still make a positive return on a total return basis. For example, if the barrier is breached and the index recovers to 90% of its initial level the investor would be returned 90% of their principal investment plus the three 5% coupons, totalling 105% over the product term.

If the barrier is breached and the index fails to recover, the product would outperform a direct holding in the underlying (excluding dividends) when the fixed coupons are taken into consideration.

According to the product provider the product will be listed on the Vienna, Stuttgart and Frankfurt stock exchanges.

 

Pricing and risk

This type of product is very popular in the US and is usually structured around short-term maturities. A typical reverse convertible comprises an income stream, a zero-coupon bond and a put option. The combination of the barrier and the coupon level reflects the volatility of the underlying. The more volatile the asset that the product has been linked to, the higher the coupon that will be offered to compensate for the higher risk of an underlying hitting the barrier. Using our usual assumptions, the probability that the barrier will be breached is approximately 2.1%. Therefore the probability of the barrier not being breached and the product paying out the maximum return of capital plus coupons is 97.9%.

With reverse convertibles it is common to include either a barrier or a buffer mechanism to reduce the risk to capital. Generally, there are three types of barrier: intra-day (American), closing-day (European) and final day. Of these, the most likely to be breached is the intra-day barrier, which can be breached at any time during the monitoring period. The extra risk associated with this type of barrier over, say, a final-day barrier (which is measured at maturity only) should be reflected in the coupon stream.

This type of product falls into the category of a short volatility strategy. Once the product has struck, its net asset value will increase if the volatility of the underlying decreases, all other factors remaining the same. No growth is needed to secure the maximum return. Only sideways, or even some downward movement in the index (as long as the barrier is not breached) is required. Therefore they are more likely to appeal to investors expecting small to moderate growth in the underlying rather than those with a bullish view, who may be looking for a higher return potential from a growth product. This structure would also appeal to those looking for fixed income returns, which may be especially appealing considering current low interest rates.

In the US, it is more common to use single stocks as underlyings for reverse convertible products. In Europe, indexes such as the Euro Stoxx 50 or FTSE 100 are more popular choices. The structures also tend to have longer maturities in Europe. US versions are short-term, high-risk investments and are often singled out as different from the longer-term growth products on the market. However, in Europe the downside risk and profile of these products is often similar to other products such as kickouts or accelerated growth products as the barrier level and underlying are the same.

The information in this analysis is taken from sources which Future Value Consultants Limited deems reliable but no guarantee is made that the information is complete or accurate and it should not be relied upon as such. Any opinions in the analyses represent those of Future Value Consultants Limited at the time of writing but are subject to change. All valuations and prices shown are indicative only and do not imply an offer or commitment of any kind. The analysis does not constitute advice or recommendations nor should it be relied upon for any purpose. No liability whatsoever is accepted by Future Value Consultants Limited or Structured Products magazine for any loss or expense incurred from using this analysis.