Libor-Linked Deep Barrier Reverse Convertibles
Libor Linked Deep Barrier Reverse Convertibles are financial products of the yield enhancement category similar to classic barrier reverse convertibles. In July 2010, investment banks suddenly started to issue these products with a coupon linked to the LIBOR rate (London Inter Bank Offer Rate, the short-term interest rate) and with barriers often set at or below 50% of the current spot price of the underlying index or stock. The maturity was often set at three or four years, far longer than the usual twelve months.
Example (Product 1 in the table below):
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The results show that all but one structure would have produced negative returns at some point in time during the last ten years. Of yourse, there were two really big crashes during that time: the internet bubble in 2000-2003 and the big recession during 2007-2009. Hence the results are dependent on the weekly data over that time, but it still shows the products in a light that is seldom shed on them.
Only the last structure (Product 10, one of my own devising, to be issued at the end of the month by a AAA issuer) would never have been hit over that period. That isn't to say that it won't be hit in the next two years, but it's as safe as can be with still a decent coupon. Note that the coupon isn't linked to the Libor rate. That's because I don't believe that the Swiss National Bank will raise rates anytime soon. Hence, I'd rather take a flat coupon, rather than lose 0.40% for the chance of a higher one I don't think will materialize. Somehow, I can't shake the feeling that these deep barrier reverse convertibles with their Libor-linked coupon are somehow designed by clever investment banks to fool the investor into thinking they buy a Floored Floater with a super-high floor. Well, some will say I like to paint the devil on the wall... Be it as it may, I also like to shorten the maturity from 3 or 4 years to 2, as it lessens the counterparty risk (bankruptcy of the issuer) for the investor.
I'll conclude by saying that once more that it would be a mistake to take these products for bond-like investments. They are rather to be taken as extremely conservative equity-like structures, useful for the investor whose target return is rather low, but who can bear the risk of an extremely unlikely large loss. And one more thing: avoid worst-of structures on single stocks. With three or four years maturity, they have a high chance of producing high losses; not something you would want in your portfolio.
- Type: Libor Linked Deep Barrier Reverse Convertible
- Underlying Asset: SMI Index
- Initial SMI Index Level (spot and strike price): 100%
- Coupon (p.a.): CHF Libor + 3.70%
- Maturity: 3 years
- Barrier: 50% of spot at issue
