Reverse Convertibles: Complex Investments

A "convertible security" is a security, such as a bond, that can be converted into a different security, such as shares of the issuing company's common stock. The company decides whether and when the conversion happens.

In a similar vein, although with very important differences, reverse convertibles—also known as “reverse convertible notes” or "reverse exchangeable securities"—are debt obligations of an issuer that are tied to the performance of one or more “reference assets” that have no relation to the issuer. These reference assets could be the stock of a different company, a stock index or some other unrelated asset.

As with other structured notes, reverse convertibles are more complicated than traditional corporate bonds. These products can offer a variety of different features, so it’s important to look closely at each offering. In particular, be sure you understand what can happen when the note matures and whether the potential outcome fits with your goals. For example, if you purchase a reverse convertible issued by, say, Bank ABC that’s linked to shares of Company XYZ stock, you might, in fact, end up holding shares of Company XYZ stock when the reverse convertible matures.

What Is a Reverse Convertible?

A reverse convertible is a type of structured product, typically in the form of a high-yield, short-term note issued by a large financial institution such as a bank. The performance of a reverse convertible note is linked to the performance of an unrelated reference asset—usually a single stock, stock index or some other asset (like a commodity) or combination (such as an equal-weighted basket) of assets.

While there can be other structures with additional features, a reverse convertible in its basic form typically has two embedded components that are combined to generate the unique payoff structure. Those components are:

• a debt instrument (usually a note and often called the "wrapper") that pays a fixed, above-market periodic coupon (for example, 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 cash—or in the form of a set amount of the reference asset (for example, a specific number of shares of stock) rather than cash—if the price of the reference asset dips below a predetermined level (often referred to as the "knock-in" level). Knock-in levels vary but are often set between 20 and 30 percent below the initial price.

Some reverse convertible notes may have call features that allow the issuer to redeem the note prior to its maturity date, have a payoff that depends on the worst-performing of multiple reference assets, or provide some exposure to capital appreciation. When you purchase a reverse convertible, you're getting a yield-enhanced bond. You don’t own, and don’t get to participate in, any upside appreciation of the reference asset. Instead, in exchange for higher coupon payments during the life of the note, you effectively “write,” or give, the issuer a put option on the reference asset. In general, the higher the expected volatility of the reference asset, the higher the fixed coupon or interest payment.

Usually with a reverse convertible, you benefit if the value of the reference asset remains stable or goes up modestly—not too much since you won’t participate in the upside. In the typical best-case scenario, if the value of the reference asset doesn’t decline or otherwise stays above the knock-in level, you can receive a high coupon for the life of the investment and the return of your full principal in cash.

In other cases, if the value of the reference asset falls or drops below the knock-in level, the issuer can pay back your principal in the form of the depreciated shares. This means you can wind up losing some—or, in the worst case, even all—of your principal. Any loss of principal, however, would be offset at least in part by the monthly or quarterly interest payments you received.

How Do Reverse Convertibles Work?

As with structured products in general, the initial investment for most reverse convertibles is $1,000 per security. They often have maturity dates ranging from three months to one year. The interest or "coupon rate" offered by a reverse convertible is usually higher than the yield on a conventional debt instrument of the same issuer with a similar term—or of an issuer with a comparable debt rating.

If the reference asset is a single stock that drops in value but doesn’t break through the knock-in price, the reverse convertible provides you with some conditional downside protection not available if you just own the underlying stock. However, for this protection, you give up any opportunity to participate in upside growth of the stock.

Depending on how the stock performs, you’ll receive either your principal back in cash or a predetermined number of shares of the stock (or cash equivalent) that amounts to less than your original investment because the stock's price has dropped. While each reverse convertible has its own terms and conditions, you’ll 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’ll 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 that level during the term of the investment. In other cases, any breach of the knock-in level may result in your receiving less than the original principal.

Be aware that reverse convertibles can have complex payout structures involving multiple variables that can make it difficult to accurately assess their risks, costs and potential benefits. Make sure you carefully review each product's terms and features.

Before You Invest

If you’re considering a reverse convertible—or it’s been suggested to you by an investment professional—ask plenty of questions, such as:

• Can they review the prospectus, prospectus supplement or other offering documents for the product with you? The prospectus will contain a more extensive and balanced discussion of the risks involved, and you should always carefully review this or similar documents prior to making any investment decision. If you have the note’s CUSIP identification, you can enter it into an internet search engine, which often will provide links to documents filed with the U.S. Securities and Exchange Commission (SEC).
• How might you lose money with this product?
• Is it possible that your fixed-income investment could be converted into an equity position, and is that suitable for you?
• Will you get interest or other cash payments and, if so, how much and how often? What are the risks that you might not receive them?
• Is there any exposure to capital appreciation?
• Could the note be called early and, if so, what does that mean for you?
• What are the fees and expenses?
• How is the investment treated for tax purposes, and what are the effects on my taxes of any principal and interest payments?

Bottom Line

A reverse convertible might make sense if you’re an investor who wants a higher stream of current income than is currently available from other bonds or bank products. But in exchange for the potential for higher yields, you’ll take on more complexity and potentially significantly greater risks by investing in these products. You’ll also need to be willing to give up any appreciation in the value of the reference asset, and you should be aware that, in some cases, your initial investment in a debt security could end up as an equity position.