J.P. Morgan & Co. has launched a synthetic convertible issue that meets investor demand for a hedge against volatility in the stock market.
According to Security and Exchange Commission documents filed on April 1, the New York-based bank plans to sell $100 million worth of convertible bonds that are tied to a basket of consumer product stocks. The custom- designed convertible premieres at a time when analysts are beginning to question whether the stock market's meteoric rise can last much longer.
"People think that the market is due for a correction," said Emmett Harty, founder and president of Parallax Group Inc., a Stamford, Conn., derivatives research and trading firm. Investors are "looking for ways to readjust the risk-reward profile of their portfolios, and investment banks have been thinking about products so that they can do this synthetically."
The J.P. Morgan issue is attractive to investors because it supplies protection against sharp upward or downward moves in the stock market, Mr. Harty said. "In 1995, no one was looking for that protection because the market was good.
"This is the first time I have seen this kind of synthetic convertible that is a registered deal," Mr. Harty added. "It's a watershed ... it's breaking ground and very clever."
Classic convertibles enable investors to exchange their issues for stock. Synthethic convertibles allow investor to take a position in a basket of stock tied to an established index.
J.P. Morgan's seven-year notes represent an innovation because they are tied to a synthetic index based on the value of 22 consumer stocks from blue-chip companies, such as Campbell Soup Co., Procter & Gamble Co. and Coca-Cola Co. In addition investors will be able to convert their bonds into cash and accrued interest as opposed to stock.
Roy Smith, a finance professor at NYU and limited partner with Goldman, Sachs & Co., said that J.P. Morgan can offset its risk in offering the securities by short-selling the basket and hedging with options or a long position in the stocks.
Although the new product has some innovative features, the concept behind synthetic securities is not new. In 1989, several banks created certificates of deposit securities that were tied to indices. Several years later, a crush of other synthetic convertibles known by acronyms such as ELKS, CHIPS, YEELDS and PERQS emerged in the over-the-counter market.
Since that time, the demand for such products has steadily increased as classic convertible securities failed to meet the demands of investors. According to Securities Data Co., a Newark, N.J.- based provider of on-line financial data bases, public and private synthetic convertible deals rose from $1.063 billion in 1994 to $2.166 billion in 1995.