Reverse Convertibles—Complex Investment Vehicles

Over the past few years, brokerage firms and banks have been issuing and marketing complex investments known in the industry as "structured products" to individual investors. These include "reverse convertibles," which are popular in part because of the high yields they offer.

 

Also known as "revertible notes" or "reverse exchangeable securities"—and 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 often described as debt instruments, they are far more complex than a traditional bond and involve elements of options trading. Reverse convertibles expose investors not only to risks traditionally associated with bonds and other fixed income products—such as the risk of issuer default and inflation risk—but also to the additional risks of the unrelated assets, which are often stocks.

 

FINRA is issuing this alert to inform investors of the features and risks of reverse convertibles. They are complex investments that often involve terms, features and risks that can be difficult for individual investors and investment professionals alike to evaluate. If you are considering a reverse convertible, be prepared to ask your broker or other financial professional lots of questions about the product's risks, features and fees and why it's right for you.

 

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—often a single stock but sometimes 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).

 

When you purchase a reverse convertible, you're getting a yield-enhanced bond. You do not own, and do not get to participate in any upside appreciation of, the underlying asset. Instead, in exchange for higher coupon payments during the life of the note, you effectively give the issuer a put option on the underlying asset.

 

You are 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 and the ownership of shares in the devaluated asset).

 

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 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. Since this means that if the stock drops in value but does not break through the knock-in price, the reverse convertible provides you with some conditional downside protection (as explained below) not available if you just own the underlying asset. For this protection, you do give up any opportunity to participate in upside growth of the underlying asset.

 

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. For example, a hypothetical payoff structure of a reverse convertible with common stock as the reference asset could result in the following scenarios:

 

ScenarioStock Price VisualAt maturity, the investor gets
1. The stock price never declines below the knock-in level, but ends below the original price.Reverse convertibles scenario 1Full return of principal in cash (despite the decline in the stock price), plus any fixed coupon payments.
2. The stock price never declines below the knock-in level, and ends above the original price.Reverse convertibles scenario 2Full return of principal in cash, plus any fixed coupon payments, but no participation in the increase in the stock price.
3. The stock price ends below the knock-in level.Reverse convertibles scenario 3Predetermined number of shares of stock (or cash equivalent), worth less than the principal amount, plus any fixed coupon payments.
4. The stock price declines below the knock-in level, but ends between the original price and knock-in level.Reverse convertibles scenario 4Predetermined number of shares of stock (or cash equivalent) worth less than the principal amount, plus any fixed coupon payments; or full return of principal in cash, plus any fixed coupon payments, depending on the issuer and product.
5. The stock price declines below the knock-in level, but ends above the original price.Reverse convertibles scenario 5Full return of principal in cash, plus any fixed coupon payments, but no participation in the increase in the stock price.

 

Generally speaking, 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).

 

The bottom line is that reverse convertibles come not only with the risks that fixed income products ordinarily carry—such as the risk of issuer default and inflation risk—but also with any additional risks of underlying asset. When the underlying asset is a stock, this means exposure to the business risks of the company as well as systemic equity market risks, including price volatility. If you are considering investing in reverse convertibles, it is critical that you look beyond the high coupon rate and focus on the risks of the underlying asset. Remember that even if the issuer of the reverse convertible is able to meet its obligations on the note—and even if the yield keeps pace with or surpasses inflation—you could wind up, when the note matures, with shares of a depreciated—or even worthless—asset that you otherwise would not have purchased. If you are not comfortable with the thought of potentially owning the underlying asset, you should not buy a reverse convertible that is based on that asset.

 

Why Do Investors Buy 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.

     

  • Convenience for some investors. Some investors may have a specific strategy in mind that a reverse convertible can replicate. For example, an investor may believe that a stock will only trade within a certain range. Instead of buying options or futures separately that together would allow the investor to profit from that bet, the investor can buy a reverse convertible.

 

What's the Downside?

 

  • Exposure to asset-related risks. When you purchase a reverse convertible, you get all the risks that debt instruments ordinarily entail, plus the risks of the underlying asset. That is why it is so critical that you fully comprehend what is behind the higher coupons these products offer—and that you fully understand the product you are buying. Remember that purchasing a reverse convertible means you are either bullish on the underlying asset itself or you are betting that the asset's volatility will be low for the term of the note.

     

  • Embedded options. When investing in a reverse convertible, you effectively buy a note from the issuer and sell a put option to the issuer simultaneously. If you don't have the risk tolerance for selling put options generally, you should question whether you want to invest in a security that contains an embedded one. If you are considering reverse convertibles, be sure you fully understand the complexities of the product and have the financial means to bear the risks.

     

  • 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.

 

Investor Tip—Be Sure to Adjust for Annualized Yields

While yields on reverse convertibles are often described on an annualized basis, fees are often expressed only for the term of the note. It is important that you consider how these numbers are described—and, if necessary, do a little math so you can make an apples-to-apples comparison of yields and fees. For example, a sales brochure for a 3-month instrument might advertise a yield of 10 percent per year and a fee of 1.5 percent, which is embedded in the $1,000 price of the product. This is not as attractive as it may sound, because a 1.5 percent fee on a 3-month product amounts to a 6 percent fee on an annualized basis.

 

  • 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. This means that you could have trouble selling reverse convertibles in a pinch and/or could lose money if you sell the reverse convertible prior to maturity. Finally, transaction costs in the secondary market for these products could be 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 health of the issuer that gives them and that issuer's ability to meet its obligations when they come due. While it is not a common occurrence that an issuer of a reverse convertible is unable to meet its obligations, it can happen.

 

Credit Ratings—They May Not Mean What You Think They Mean

Credit ratings are a way of assessing default and credit risk—in other words, the creditworthiness of the issuer. While the note component of a reverse convertible carries the issuer's credit rating, that rating does not reflect the risk that the price of the unrelated underlying asset will fall below the knock-in level, resulting in a loss of principal. A reverse convertible packaged by a highly rated issuer could be linked to a poorly rated company—or to a highly rated company whose stock performs poorly.

For more information on credit ratings, read FINRA's Smart Bond Investing.

 

  • Tax considerations. The tax treatment of reverse convertibles is complicated and uncertain. Investors should consult with their tax advisors and read the tax risk disclosures in their prospectuses and other offering documents. Although these documents typically provide instructions on how investors should treat reverse convertibles on their tax returns, there is no guarantee that the IRS or a court would agree with that tax treatment. Little guidance in the way of court decisions or published IRS rulings has been issued on this topic. When considering the tax consequences of any investment, you may want to consult with a tax advisor.

     

  • Call risk. Some reverse convertibles have "call provisions" that allow the issuer, at its sole discretion, to redeem the investment before it matures. If this is the case, you would not receive any subsequent coupon payments that you were promised for the term of the reverse convertible, and you would immediately receive your principal in either cash or stock. Also, if a reverse convertible is called, it might be difficult or impossible to find an equivalent investment paying rates as high as the original rate (which is known as reinvestment risk). You should carefully read the prospectus to learn whether there is a call provision and what its specific terms are.

     

  • Loss of principal. While some other structured products may offer principal protection, reverse convertibles do not. The only potential protection against loss they might offer is the conditional downside protection of the knock-in price. Depending on whether the price of the underlying stock or asset breaches the knock-in level, you could lose some—or even all—of your principal. You may be told that, in a down market, you at least "walk away with something." But don't forget that the stock you receive in the case of a breach could, for example, be shares in a company that is about to declare bankruptcy—or that you don't want to own or doesn't make sense for your circumstances. This risk is why research must be done on the underlying asset and why you should think twice about owning a reverse convertible if you are not comfortable with the thought of potentially owning the underlying asset.

     

  • 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.

 

How to Protect Yourself

 

  • Be wary of any advertisements or sales literature sug