Reverse convertible notes hot in low-yield environment

Investors snapping up the 10%-plus annual coupons on recent reverse convertible notes may be playing with fire, according to experts familiar with the stock-linked structured products.

Issued by securities firms and generating commissions that often exceed 2%, reverse convertibles are high-yielding short-term notes that can convert to an underlying stock, depending on the stock’s price movement.

Sensing that investors may be open to such products in a low-yield environment, issuers have stepped up production of the controversial securities, issuing 632 reverse convertibles in the fourth quarter of last year, compared with 178 in the comparable period of 2008, according to data from Future Value Consultants Ltd.

Sold as a relatively safe fixed-income investment to high-net-worth investors, reverse convertible securities are actually equity investments coupled with a short-term note. Instead of a full return of principal as with a bond, they can deliver shares or cash worth far less than the value of an original investment.

The often unexpected payoff at the end of a note’s term is what concerns observers.

“We’ve received about 15 calls from investors regarding reverse converts in the last six months; in the 10 prior years, we never received one call,” said Andrew Stoltmann, a plaintiff’s attorney.

The surprises come from the structure of the product.

As an example, suppose an investor purchases $1,000 of a one-year reverse convertible linked to the price of Intel Corp. (INTC). Intel stock is $25 at issuance, and the coupon is 15%. If the price of Intel at maturity of the note is at or above the issuance price, all the investor will receive is a return of principal and $150 in interest, for a maximum of $1,150.

However, if the price at maturity is below the initial price, say, $10, the investor receives the number of shares of Intel he or she would have bought at the time of the issue — in this case, 40 shares ($1,000 divided by $25) worth $400 — plus the $150 in interest, for a total of $550.

A more common — and complex — structure involves a “knock-in.” Here, the price risk related to the linked security is typically set at 70% to 80% of the initial “reference” price.

Using the Intel example, in which the reference price is $25, the knock-in level may be set at $20. In these notes, investors receive the full principal back at maturity if that level is never breached. If it is, and Intel stock is trading below $25 at maturity, the investor receives Intel shares as repayment of principal.

“Many times, investors don’t realize that the odds of the underlying stock dropping are great,” said Larry Swedroe, a principal and co-founder of Buckingham Asset Management LLC, which manages more than $2 billion in assets.

But issuers are well-aware of the odds, he said.

“Obviously, they don’t issue something with a high yield when they know the real cost,” Mr. Swedroe added. “If something has a high yield, there is high risk.”

For investors, however, that risk is too hard to gauge, because reverse convertibles are so complicated, said Eric Jacobson, a fixed-income specialist with Morningstar Inc. He doesn’t recommend the securities.

“I’m automatically suspicious of any investment that is extremely complex and targeted mostly to individual investors,” he said. “It’s usually impossible for an individual to accurately assess valuation or pricing.”

Complexity creates tax issues as well. Because reverse convertibles consist of two components, a debt instrument and an option, they are subject to special tax treatment: Gains are taxed as interest income, while loses can be either long- or short-term.

In a low-yield environment, however, reverse convertibles fill a niche, said Lloyd Raines, a financial consultant with RBC Wealth Management, a unit of the Royal Bank of Canada, which issues the notes.

As long as investors understand that they may not receive a return of principal and instead end up with the underlying stock — which they would be willing to hold anyway — the sparing use of reverse convertible bonds can make sense, he said.

A reverse convertible exchange-traded fund now in registration may be a possible alternative, industry experts said.

The U.S. Equity Reverse Convertible Index Fund, the first ETF from Rich Investment Solutions LLC, will seek to replicate synthetically the returns of reverse convertible notes by following an index of over-the-counter put options written on 13 stocks in the S&P 500. Because the fund wouldn’t actually hold convertible notes, investors wouldn’t be hit with big commissions on those securities. Instead, they would pay an expected 0.9% in ETF expenses and relatively low brokerage commissions.

The ETF — created by Kevin Rich, the former chief executive of DB Commodity Services LLC, which launched the first commodities ETF — will also offer instant diversification, which is not the case with individual reverse convertible notes, Mr. Swedroe said.

But that doesn’t mean investors should rush out and buy the ETF when it hits the market, he said.

“This ETF just makes you less dumb,” he said.

E-mail David Hoffman at [email protected].