Reverse Convertible Notes: Plenty of Risk Without Limited Rewards
Reverse convertible notes are structured products, which allow retail investors to invest in debt. Reverse convertible notes might also be referred to as “revertible notes” or “reverse exchangeable securities.” These financial instruments are an especially complex version of structured products that utilize bonds and risky options trading. Brokers might promote reverse convertible notes as having two advantages:
- A short-term maturity date,
- Better returns than traditional bonds.
Brokers might also describe reverse convertible notes as “yield enhanced bonds.” This description is extremely misleading and is far from the full picture. The Financial Industry Regulatory Authority (FINRA) has warned investors about the risks and misnomers surrounding reverse convertible notes. Investors should learn how reverse convertible notes work to evaluate their inherent risks, especially following a $1 million fine to RBC Capital Markets for selling reverse convertible notes that did not suit their investor’s needs.
Reverse Convertible Notes Facts
- Reverse convertible notes usually cost $1,000 per note.
- They may advertise the possibility of extremely high yields. These yields typically range from 8% to as much as 30%.
- Reverse convertible notes take from three months to one year to mature.
- Reverse convertible notes have two components: a debt instrument and a put option.
1. Debt Instrument – Bonds
Bonds offer modest returns, which largely depend on interest rates. Bonds pay investors their yield at set intervals. These payments are known as “coupons.”
2. Put Options
Option contracts give investors the right but not the obligation to sell a share at a certain price by a specified deadline. In the case of a reverse convertible note, the issuer is buying the put option, not the investor. If the share price declines, the issuer makes money, and investors lose part of their investment. Should prices of shares remain the same or increase, the investor will earn a return.
Investors should know what kind of payout structure their reverse convertible note offers: basic or knock-in.
Basic structures repay reverse convertible note investors the full amount of their principal payments, plus any coupon payments, so long as the share prices of the underlying investment remain at their original price or increase. If they drop below the original price, the investor will receive the shares of the underlying investment instead of their principal payment. This is a loss for the investor as the price of the shares has declined.
Issuers might set a “knock-in” level for the underlying investments. Share prices may decline in value, but it will not affect the investor if prices remain above the knock-in price. This structure offers some protection for investors. With a knock-in price, it makes no difference to investors if the shares increase or decrease in value, as long as they remain above the knock-in price.
If the share prices drop below the knock-in level, the investor will not receive their principal payment back, but instead the less-valuable underlying shares.
Investors should make sure they understand how knock-in levels might affect their reverse convertible notes. The following examples illustrate how easy it is for an investor to lose money.
Here are the basic knock-in scenarios:
If the shares decline in value but do not reach the knock-in level, the investor will receive their entire principal investment back, plus the coupon payments. Brokers might characterize this as protection from loss—investors who fully owned the underlying stock would have lost money. This characterization ignores the fact that many stocks and investment funds are much lower risk than put options trading.
If the shares fall below the knock-in level but then recover and end up higher than the original price by the maturity date, the investor receives the principal payment and the coupon payments. They do not, however, profit from the increase in stock prices.
If the reverse convertible notes’ shares drop below the knock-in level and remain there by the maturity date, the investor will lose money. Instead of receiving their principal investment back, they will receive the underlying shares and suffer a loss.
If shares dip below the knock-in level and then recover but do not reach the original price, the issuer might offer a predetermined number of stocks or cash equivalent. Alternatively, they may offer a return of principal plus coupon payouts. It depends on the issuer.
Investors should understand how the issuer handles knock-in levels before they invest in a reverse convertible note.
“Yield-enhanced bond” has a nice ring to it, but investors beware: Those yields are not guaranteed. If the underlying stocks in the put option do not perform as expected, the investor will lose money. FINRA emphasizes that reverse convertible notes combine risks of debt instruments plus the risks of options trading. If investors consider options trading too risky, they should apply the same degree of caution to reverse convertible notes.
These are just some of the risks that brokers should highlight when they discuss reverse convertible notes with their investors:
Call Provisions: Reverse convertible notes contracts might come with call provisions, which give the issuer the right to cancel the note at any time and return the principle as either cash or stock. Investors can find information about call provisions in the prospectus.
Illiquidity: Reverse convertible notes typically mature in a year, and investors must be absolutely sure they will not need the funds before investing. There is not always a secondary market for reverse convertible notes, meaning that investors might struggle to sell their notes.
Expensive Fees: It is almost impossible for investors to determine how much they are paying in fees. This is another aspect of reverse convertible notes making them difficult for investors to evaluate.
Multi-Stock Reverse Convertibles have an even higher risk of reaching the knock-in level. Naturally, these offer higher returns.
Limited Rewards: Investors do not profit directly from the performance of the underlying asset. The investor’s profits are tied to share performance, but they do not profit from the shares themselves.
Credit Quality: Reverse convertible notes are “unsecured debt.” If the issuer defaults on their bond coupon payments, investors may have little recourse to recover their money.
Reverse Convertible Note Fraud: When to Call a Lawyer
FINRA warns that brokers may downplay the risks of reverse convertible notes. For instance, brokers may not refer to them as “structured products” to avoid risky connotations. Brokers may also engage in misconduct by recommending a complex product they do not fully understand. Brokers must follow FINRA regulations and only recommend investments if they can fully evaluate their risk and establish that they suit the individual needs of their investor. If you believe it should have been clear that reverse convertible notes were too illiquid or high-risk for your financial goals, reach out to our securities fraud attorneys today for a free case evaluation.