Complex Investments Usually Favor the Issuer, Not You

The other day I was called by a financial reporter to help her dissect a reverse convertible offering by Credit Suisse. I told her I could reject the offering without even hearing the terms.

I explained that Credit Suisse's objective is to raise capital at the lowest cost. Providing investors with high returns defeats that purpose. Therefore, investors can be 100 percent certain the complexity of the structure results in lower costs than if a simple note was issued.

The basics of the one-year note to be offered on Nov. 1 were:

• A high coupon of 13 ½ to 15 ½ percent, to be determined at issuance.
• Callable at any time.
• Repayment would be made at par (100) unless the price of either Apple or Microsoft fell more than 30 percent from its price at issuance. In that case, payment would be at par plus the return of the worst performing stock.

While many investors believe the likelihood of either Apple or Microsoft falling 30 percent is remote, the risk is actually high. First, stocks are highly volatile. The annual standard deviation of the S&P 500 Index has been about 20 percent, and the volatility of individual stocks is much higher. Second, the odds of either Apple or Microsoft falling at least 30 percent are higher than the odds of one of them doing so.

The bottom line is that investors have sold an expensive put to Credit Suisse -- the right to pay off the note based on the value of either stock at maturity -- at a cheap price. On top of that, investors run the risk of Credit Suisse exercising the call option early, meaning they won't get the coupon for the full period. (They will do this if they perceive that there's little risk of either stock falling at least 30 percent.)

Here's how it works. If neither Apple nor Microsoft falls 30 percent, the investor earns the coupon, say 14 percent. However, if either falls 31 percent, the investor earns the coupon of 14 percent and gets paid off at 69 cents, producing a net loss of 17 percent. It's even possible that one of the stocks will lose 100 percent, producing a loss of 86 percent. The maximum return is 14 percent. The maximum loss is 86 percent.

Using a calculator provided by Bloomberg, we determined that the yield on the note should be more than 17 percent based on the embedded put options. And that doesn't account for either the credit risk of the issuer or the lack of liquidity of the note, both of which require further risk premiums. It also doesn't account for the issuer's right to call the note prior to maturity.

To properly evaluate this security, you have to value the complex options. What are the odds the individual investor can properly value the security? Credit Suisse knows it's close to zero. It's important to note that academic research has shown that the yields on these securities are underpriced by 3 percent to 12 percent. Remember, if you can't identify the sucker at the poker table, you're the sucker.

Further reading: For more on these securities, see my post explaining why reverse convertibles are a bad investment.