Bad Investments: Reverse Convertibles

Last Updated Jul 2, 2009 10:01 AM EDT

Generally speaking, the more complex an investment product, the faster you should run from it. In nearly all cases, the complexity is designed to favor the issuer. Over the next few days, we'll look at a group of these instruments collectively called structured note products. Today, we'll look at reverse convertibles.

Reverse convertibles are unsecured short-term notes that are linked to the price of an underlying stock (typically not the stock of the issuer). The security comes with a high coupon rate (from 7 to as much as 25 percent). At maturity, the investor will receive the interest payment plus either 100 percent of his original investment amount or a predetermined number of shares of the underlying stock.

In return for the high coupon and the credit risk of the issuer, investors bear either all of the downside risk of the underlying equity (under what is known as the basic structure) or much of the downside risk (under what is known as the "knock-in" structure). However, the upside is limited to the interest payment. The following are examples of the two structures.

Basic structure An investor purchases $1,000 of a one-year reverse convertible linked to the price of Intel. Assume the price of Intel was 25 at issuance and the coupon is 15 percent. If the price of Intel at maturity is 25 or greater, the investor will receive $150 in interest and the return of his principal, for a total of $1,150. However, if the price at maturity is say 10, the investor receives $150 in interest plus 40 shares (1,000 divided by 25) of Intel, shares that are now worth just $400. Thus, the investor receives a total value of $550, losing 45 percent of his investment.

Knock-in structure The knock-in structure has one significant difference over the basic structure -- the "knock-in level" is set about 70 percent to 80 percent below the stock price at issuance. Using the same example, the price of Intel is 25 at issuance. The knock-in level might be 20. Investors receive the coupon payment plus full principal at maturity if the knock-in level is never breached. But if the knock-in level is ever breached, and Intel is trading below 25 at maturity, the investor would receive Intel shares in repayment of principal. As under the basic structure, the number of shares received is based on the reference price.

You should always keep in mind that companies issuing products such as these aren't doing it out of the kindness of their hearts. Their goal is to issue securities at the lowest cost to them while making these investments seem attractive to you.

Thus, it is no surprise that academic research has found that the yields are underpriced by between 3 percent and 12 percent. In addition to buying an overpriced security, you are giving up the upside benefit of the returns (because your gains are limited to the coupon), while fully participating in the downside risk.

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    Larry Swedroe is a principal and director of research for the BAM Alliance. He has authored or co-authored 12 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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