Reversal of Fortune

By Rudy Aguilera -Principal, Helios LLC
As an advisor, you have probably been pitched a reverse convertible. If you haven’t, don’t worry -- by the time you are finished reading this article, you will probably have a prospectus for one in your inbox. With Treasuries generating anemic yields, it is hard to turn down the double-digit coupons offered by reputable investment banks. But what exactly is a reverse convertible?

A reverse convertible provides investors with a coupon in exchange for accepting the risk that the underlying stock may decline in value. The maximum profit in a reverse convertible is limited to the coupon received. Replace coupon with premium and it’s easy to see that a reverse convertible is nothing more than a cash-secured put sale with some added risks and costs.

The first thing you must understand is that the reverse convertible has no affiliation with the underlying stock. It is simply a product whose performance is tied to the performance of the underlying security. Therefore, a reverse convertible is a derivative, just like a put option.

However, unlike an exchange-traded put option, reverse convertibles expose investors to counterparty risk. A reverse convertible is nothing more than an unsecured debt obligation of the issuing investment bank. If a liquidity event were to occur, investors in the reverse convertibles issued by the firm would have to stand in line with other debt holders hoping to be made whole.

Investment banks do not hold a monopoly on liquidity events. If an investor needs to liquidate their position in a reverse convertible prior to maturity, they will often times be dealing with one purchaser -- the issuer of the note. Now think about this for a moment. Would you rather transact in a market with thousands of participants competing for your order or would you rather deal with one purchaser who will dictate the price you receive? For this very reason, prospectuses for reverse convertibles always include an ominous section on liquidity risks.

Similar to sellers of cash-secured puts, holders of reverse convertibles are not entitled to receive the dividends distributed by the underlying stock. However, unlike an investor who sells a cash-secured put and receives the entire premium at the time of the transaction, investors who purchase reverse convertibles must collect a coupon over the life of the note. Consequently, investors holding reverse convertibles must recognize interest income as it is received whereas sellers of cash-secured puts may defer taxation until they engage in a closing transaction.