Reverse convertibles are complex, structured investment products that have become increasingly popular with brokerage firms, banks and individual investors because of their potential for high yields.
Sometimes called “revertible notes” or “reverse exchangeable securities,” they are sold under a variety of names proprietary to the brokerage firm or bank that is marketing or selling the product. Often, they contain no indication that they are structured products, investment instruments that are synthesized by pooling various assets.
With a reverse convertible, the issuer’s obligation to make payments is tied to the performance of an unrelated security or group of securities. These are quite often risky equity securities. While reverse convertibles share a few traits with more common debt instruments, they are more complex and far more risky than traditional bonds because they involve elements of options trading.
Components of Reverse Convertibles
Generally, a reverse convertible feature a high-yield, short-term note linked to the performance of an unrelated reference asset. The reference asset can be a single stock, a basket of stocks or an index, although other kinds of reference assets are possible.
A reverse convertible usually has two components:
1. The debt instrument or note, often called the wrapper. The note coupons pay an above-market yield on a monthly or quarterly basis.
2. The derivative or put option that allows the issuer the right to repay principal to the investor with a set amount of the reference asset instead of cash if the price of the asset dips below a predetermined price, often called the knock-in level.
Be aware that reverse convertibles do not provide investors with the possible upside appreciation that can come from owning equities. While an investor can collect on the high-interest coupon, the principal is all that is ever paid back. In exchange for the higher coupon payments during the life of the note, an investor in a reverse convertible gives the issuer a put option, meaning that the issuer can force the investor to buy a set portion of the underlying asset if it falls below a certain price.
Like most investments, a prediction is involved: the reverse convertible investor is betting that the value of the underlying asset will remain stable or appreciate, while the issuer is betting the price will fall.
In the best case scenario for the investor, the value of the underlying asset will stay above the knock-in level, allowing the investor to receive the high coupon yield for the life of the investment followed by the return of the full amount of the principal in cash.
In the worst case scenario, the value of the underlying asset falls below the knock-in level, and the issuer exercises the put option, effectively paying back the principal in the form of depreciated assets. Investors can lose the entire amount of their principal, partially offset by the monthly or quarterly interest payments received.
While reverse convertibles may make sense for investors on the hunt for a high income stream, the downside risk is also high. These products are not suitable for investors who main goal is to protect principal.
The Details of Reverse Convertibles
For an initial investment -- typically $1,000 per security -- the investor receives a note with a maturity date ranging from three months to one year. The note usually has a coupon rate that is much higher than a conventional debt instrument. In fact, the annualized coupon rates of reverse convertibles can reach up to 30 percent. This higher yield reflects the risk that the investor could receive less than a full return of principal if the reference asset falls below the knock-in level. For a single stock reverse convertible, a typical knock-in level is 20 percent below the original price.
Depending on the performance of the reference asset, investors either receive their principal back in cash or a predetermined portion of the underlying asset or its cash equivalent. If an investor receives a predetermined portion of the underlying asset or its cash equivalent, the amount will be less than the original investment because it means the asset's price has dropped and the issuer has exercised the put option.
On the other hand, investors will generally receive the full amount of their principal in cash if the reference asset’s price remains above the knock-in level for the entire term of the note.
The terms of reverse convertibles vary, however. In some cases, investors receive a full return of principal if the price of the reference asset is above the knock-in level at maturity, even though it dipped below the knock-in level at points during the life of the note. In other cases, if the price ever falls below the knock-in level at all, an investor will receive back less than the original principal.
Investors also need to be aware that they will not receive any return on the appreciation of the reference asset during the life of the note.
The above is a simplified version of the way reverse convertibles operate. These instruments can have extremely complex pay-out structures with multiple variables that make it difficult to accurately assess risks, costs and potential benefits.
As with most investment, the higher the potential yield, the higher the volatility. With a reverse convertible, the yield is coupon rate paid on the note, and the highest rates are paid on the riskiest reference assets. This means there is a higher probability that the asset’s price will fall below the knock-in level, and investors will lose all or part of their principal at maturity. The greater the yield, the higher the risk of losing the entire amount of the principal.
Investors who expect stock prices to remain flat may expect to get a better return from a reverse convertible than from the stock itself, but the coupon rates for reverse convertibles linked to flat or stable stocks are not nearly as high as those linked to volatile stocks.
More on the Downside
Investors’ exposure to the risks attending the underlying asset of a reverse convertible comes in the form of the embedded option. In effect, investors buy a note from the issuer and sell the issuer a put option simultaneously.
This does not mean reverse convertibles escape the costs and risks that attach to more traditional debt instruments. These include:
Fees. Issuers charge an up-front fee for packaging a reverse convertible's individual components. The fee typically ranges from less than 1 percent to 8 percent or more. A prospectus may call this fee a “built-in cost” or “cost of hedging,” and the exact amount is not usually disclosed. Investment experts have said it is virtually impossible for individual investors to determine the amount of this upfront fee because they would need to break down the reverse convertible into its parts and then somehow determining what it would cost for the investors to assemble the instrument themselves. Therefore, it can be hard to tell whether a reverse convertible is a good deal.
Potential liquidity risk. Like most structured products, the secondary market for reverse convertibles is limited. They are often highly illiquid. Even if the issuer says it intends to maintain a secondary market, it is not required to do so, and the liquidity risk premiums are most likely high.
Credit quality. A reverse convertible is an unsecured senior debt obligation of the issuer, and investors bear the risk of the issuer’s default. If the issuer runs into financial trouble, it may not be able to meet its obligations when due.
Tax considerations. The tax treatment of reverse convertibles is complicated and uncertain.
Call risk. Some reverse convertibles have call provisions that allow the issuer to redeem the note before maturity at the issuer’s sole discretion.
Conflicts of interest. Issuers might engage in activities that represent conflicts of interest with respect to investors in its reverse convertibles. For instance, the issuer could have a business relationship with the company whose stock is the reference asset and perhaps even be writing research reports about the company. If an issuer or its affiliate were to publish a research report unfavorable to the stock that is the reference asset, for example, this could play a part in driving the share price below the knock-in level. Such conflicts may go undisclosed.
Nicholas J. Guiliano, Esquire, Guiliano Law Firm, P.C. Practice limited to the representation of investors in arbitration claims against stockbrokers for fraud, the sale of unsuitable investments, breach of fiduciary duty, failure to supervise. National Practice. Contingent Fee. Free Consultation. (877) SEC-ATTY.
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