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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):
  • 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
Let's suppose that in this example, the Libor rate is currently set at 0.50%. The investor receives a guaranteed yearly coupon of 3.70% + 0.50% = 4.20%. If on the following year, interest rates rise and the Libor rate quotes at 1.00%, the coupon in the second year will then amount to 4.70%, etc., until maturity. The invested capital is protected against losses by the barrier, unless the SMI Index drops by 50% or more from its initial level and breaks through it. Should the latter occur, the capital protection disappears and the investor will most likely incur a loss amounting to the negative performance of the index. A drop of fifty percent may seem like a long way to go for the SMI, and the product may induce the investor to believe that he is buying a bond replacement product. Not quite! A backtest over the last 10 years (August 2000 to August 2010) shows that this product would have put a dent in an investor's finances in 17% (!) of all occurrences (using weekly data) - on average quite a large dent, in fact. If the underlying asset drops by 50% and breaks through the barrier, it is likely that the loss will be accordingly high, unless the asset recovers an doubles in value until maturity. I backtested other structures, all of which are being issued by various investment banks as of August 2010: [caption id="attachment_78" align="alignleft" width="300" caption="Backtest Deep Barrier Reverse Convertibles"]Backtest Deep Barrier Reverse Convertibles[/caption] 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.