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Reverse Convertibles: An Opportunity to Lose Your Money

Last year, sales of reverse convertibles hit an all-time high, proving once again that investors can't seem to avoid products meant to be sold, not bought. Tiya Lim, my co-author on The Only Guide You'll Ever Need for the Right Financial Plan, takes a deeper look at these poor investments.

Last year, Larry warned investors about reverse convertibles. To recap, reverse convertibles are unsecured short-term notes that are linked to the price of an underlying stock. 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 or most of the downside risk of the underlying equity. However, the upside is limited to the interest payment.

The promise of high yields make reverse convertibles seem very appealing, especially during low interest rate environments. According to Bloomberg, last year sales of structured notes rose 46 percent to a record $49.4 billion.

However, investors weren't rewarded for their efforts. Bloomberg noted that instead of earning the high coupon, on average, investors actually lost 1 percent on reverse convertible securities maturing by November 30, 2010 - again showing that there's a big difference between yield and return. Compare that to the S&P 500 Index (returning 8.6 percent over the same period) or the Barclay's Capital Intermediate US Government Bond Index (which returned 6.4 percent).

Sales were mostly to individual investors as professional money managers and institutions know they can recreate the same investment vehicle on their own at a much lower cost. Those costs, in the form of bank fees, are another feature that protects the issuer at a significant cost to the investor. Bloomberg found that the average reverse convertible charged about 6 percent per year. ICI estimates that the average equity mutual fund charges an average of one percent per year. Those costs are most likely what eroded many reverse convertible returns.

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.

And yet purchases of reverse convertibles hit an all time high last year. At fees of 6 percent, investors paid roughly $3 billion to banks in their quest for higher yields. Be careful of what gets marketed to you. As one money manager stated, "I doubt these are being pitched as an opportunity to lose 1 percent."

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