Reverse Convertibles

Brokerage firms and banks have been issuing and marketing complex investments known in the industry as “structured products” to individual investors. Among these structured investment products are “reverse convertibles,” which are popular in part because of the high yields they offer.

Also known as “revertible notes” or “reverse exchangeable securities”, these instruments are sold under a variety of proprietary names that may or may not use the term “structured” to describe the product. Reverse convertibles are debt obligations of the issuer that are tied to the performance of an unrelated security or basket of securities. Although they are sometimes described as debt instruments, they are more complex than traditional bonds and involve elements of options trading. Reverse convertibles expose investors to heightened risks not associated with bonds.

What Is a Reverse Convertible?

A reverse convertible is a structured product that generally consists of a high-yield, short-term note of the issuer that is linked to the performance of an unrelated reference asset, it might be a single stock or a basket of stocks, an index or some other asset. The product works like a package of financial instruments that typically has two components:

• a debt instrument (usually a note and often called the “wrapper”) that pays an above-market coupon (on a monthly or quarterly basis); and
• a derivative, in the form of a put option, that gives the issuer the right to repay principal to the investor in the form of a set amount of the underlying asset, rather than cash, if the price of the underlying asset dips below a predetermined price (often referred to as the “knock-in” level).

Reverse convertibles do not provide the investor with any significant upside appreciation associated with owning equities. Instead, in exchange for higher coupon payments during the life of the reverse convertible note, the investor effectively give the issuer a put option on the underlying asset. The investor is in effect betting that the value of the underlying asset will remain stable or go up, while the issuer is betting that the price will fall. In the typical best case scenario, if the value of the underlying asset stays above the knock-in level or even rises, you can receive a high coupon for the life of the investment and the return of your full principal in cash. In the worst case, if the value of the underlying asset drops below the knock-in level, the issuer can pay back your principal in the form of the depreciated asset—which means you can wind up losing some, or even all, of your principal (offset only partially by the monthly or quarterly interest payments you received).

A reverse convertible might make sense for an investor who wants a higher stream of current income than is currently available from other bonds or bank products—and who is willing to give up any appreciation in the value of the underlying asset. But, in exchange for these higher yields, investors in these products take on significantly greater downside risks.

How Do Reverse Convertibles Work?

The initial investment for most reverse convertibles is $1,000 per security, and most have maturity dates ranging from three months to one year. The interest or “coupon rate” on the note component of a reverse convertible is usually higher than the yield on a conventional debt instrument of the issuer — or of an issuer with a comparable debt rating. For example, some recently issued reverse convertibles have annualized coupon rates of up to 30 percent. A reverse convertible’s higher yield reflects the risk that, instead of a full return of principal at maturity, the investor could receive less than the full return of principal if the value of the unrelated reference asset falls below the knock-in level the issuer sets. For a reference asset that is a single stock, the knock-in level can be 20 percent or more below the original price.

Depending on how the underlying asset performs, you will receive either your principal back in cash or a predetermined number of shares of the underlying stock or asset (or cash equivalent), which amounts to less than your original investment (because the asset’s price has dropped). While each reverse convertible has its own terms and conditions, you will generally receive the full amount of your principal in cash if the price of the reference asset remains above the knock-in level throughout the life of the note. In some cases, you will also receive a full return of principal if the price of the reference asset ends above the knock-in level at maturity, even if it has fallen below it during the term of the investment — although in other cases, any breach of the knock-in level will result in your receiving less than the original principal. However, you typically will not participate in any appreciation in the value of the reference asset during the life of the note.

Reverse convertibles can have complex pay-out structures involving multiple variables that can make it difficult to accurately assess their risks, costs and potential benefits.

Generally, the higher the coupon rate the note pays, the higher the expected volatility of the reference asset. In turn, the more volatile the reference asset, the greater the likelihood that the knock-in level will be breached, and the investor could receive less than a full return of principal at maturity (as illustrated in cases three and four above).

Why Do Brokerage Firms Market Reverse Convertibles?

• High coupon rate or “stated yield.” Reverse convertibles can offer coupons from 7 percent to 30 percent. Typically, however, a higher coupon rate indicates higher volatility in the underlying stock or asset. This translates into a greater likelihood that the knock-in level will be breached during the term of the reverse convertible and that investors will receive stock (or the current cash value of the asset) at maturity worth considerably less than the full return of principal in cash. As a general rule, the higher the offered yield, the greater the risk of losing all or a portion of the principal invested.
• Expectation of flat markets. Investors who are betting that a stock price will be relatively flat may expect to do better with a reverse convertible than buying the stock itself. But remember, the coupon rates for reverse convertibles linked to relatively stable stocks may not be as high as for those linked to volatile stocks.

What’s the Downside?

• Exposure to asset-related risks. A reverse convertible carries all the risks that debt instruments ordinarily entail, plus the risks of the underlying asset.
• Embedded options. The investor effectively buy a note from the issuer and sell a put option to the issuer simultaneously.
• Fees. Issuers charge an up-front embedded fee to investors—typically ranging from less than 1 percent to 8 percent or more—for assembling and packaging a reverse convertible’s individual components. Prospectuses may call this fee “built-in costs” or “costs of hedging,” although the exact amount is not typically disclosed to the investor. Industry experts say that it is all but impossible for individual investors to determine the size of this embedded fee (and therefore whether the reverse convertible represents a good deal), because that would require dissecting the reverse convertible’s parts and determining what it would cost for the investor to obtain and assemble them.
• Potential liquidity risk. As is the case with virtually all structured products, secondary trading for reverse convertibles will generally be limited — which means reverse convertibles can be highly illiquid. Even if the issuer of a reverse convertible states that it intends to maintain a secondary market, it is not required to do so. Secondary market liquidity risk premium are almost certainly high.
• Credit quality. A reverse convertible is an unsecured senior debt obligation of the issuer, meaning that the issuer is obligated to make the interest payments and final payments as promised. These promises, including any principal protection, are only as good as the financial viability of the issuer that gives them and that issuer’s ability to meet its obligations when they come 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, at its sole discretion, to redeem the investment before it matures.
• Conflicts of interest. An issuer may conduct activities that could represent conflicts of interest with respect to investors of its reverse convertibles. For example, the issuer might engage in regular business activities with the company whose stock is the underlying asset, such as investment banking, asset management or other advisory services and writing research reports about the company. An affiliate of the issuer, for example, might publish research reports that are unfavorable to the stock and could hurt the performance of a reverse convertible that is linked to that stock. Undisclosed conflicts may exist.