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Reversal of Fortune - Continued

While we are on the subject of taxation, if you flip through the prospectus for a reverse convertible, you will see that the investment bank is categorizing the coupon they distribute into two components -- a debt component and an option component. Since the reverse convertible represents an obligation you are compensated to fulfill, you are required to treat a portion of the coupon interest as a put premium, while treating the remainder as interest on the cash you have deposited to fulfill your purchase obligation. So if the investment bank and the IRS both see this transaction as a cash-secured put sale, why shouldn’t you? This leaves us with a question -- how much money are you leaving on the table by purchasing a cash-secured put sale from an investment bank?
 

Reverse Convertible
Cash-Secured Put Sale
Reference Stock
Underlying Stock
Coupon
Premium
Maturity
Expiration
Reference Price
Strike Price
Pricing Date
Trade Date

 

During the most recent Options Course for Advisors and Planners, we deconstructed a recently issued reverse convertible. While the issue paid a healthy coupon of 10.75%, it was dwarfed by the true value of the embedded put premium, which represented 15.50% of the corresponding stock’s price. By selling an embedded cash-secured put sale to the investment bank through a reverse convertible purchase, you are reducing your clients’ possible return by 31%. Furthermore, your clients are taking on the credit risk of the issuer without proper compensation. If we place our collateral yield for the aforementioned cash-secured put sale in a portfolio of investment grade corporate debt, we can boost the total return on the position to over 19%.

Now as appealing as these numbers may seem, remember that both reverse convertibles and cash-secured put sales expose the investor to the risk of a substantial decline in the underlying security. Think of incorporating long-dated cash-secured put sales as a way to complement, and not supplant, your fixed-income allocations.

Rudy Aguilera is a founding principal with Helios, an independent fee-only Registered Investment Advisor that offers objective investment counsel free from industry and product affiliations. Helios works closely with advisory firms so that they may expand their suite of services to include low-cost, diversified, tax-efficient portfolios that exhibit less volatility than traditional equity investments. You can reach Mr. Aguilera at articles@heliosadvisors.com.

 

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