Reverse Convertible Securities

Education graphics RC v2bGeneral Description

Reverse Convertible Securities are non-principal protected short-term investments tied to one or more underlying stocks. There are a wide variety of companies that can be represented in these underlying shares, from small-cap firms to Fortune 500 companies.

Reverse Convertibles may provide a coupon rate higher than that of a comparably-rated traditional corporate bond of the same maturity. As long as the price of the underlying stock (also called the reference share) never closes at or below the Knock-In (downside barrier) level, then, even if at maturity the stock price is lower than the initial price, the investor receives 100% of the initial investment in cash at maturity.

However, if the stock’s closing price on the final determination date is lower than it was initially and the stock closed on any single day at or below the Knock-In price level, then the investor receives a predetermined quantity of shares instead of 100% of the initial investment in cash. The coupon payments are unaffected.

In addition to the stated coupon that is paid monthly or quarterly, at maturity the investor receives either 100% of the initial investment principal in cash, or a pre-specified number of shares of the underlying stock are delivered in lieu of full cash payment. If shares are delivered, the value of those shares will be less than the amount originally invested. The investor’s potential return is limited to the security’s coupon rate; the investor does not share in any appreciation of the underlying stock.

Multi-Stock Reverse Convertibles

Typically referred to as a Multi-Stock “Worst of Basket”, this type of Reverse Convertible has a “basket” of stocks (instead of one underlying stock). The “Worst of Basket” has a Knock-In feature that permits the issuer to deliver at maturity the shares of the worst-performing stock in the basket – if the closing price of at least one of the stocks falls below the predetermined Knock-In level and one or more of the basket securities are below their initial price on the final determination date. The worst-performing stock is determined on the basis of percentage of price decline. The stock that the investor receives may even be a stock that never reached its Knock-In level. Otherwise, if none of the basket components have closed at or below the Knock-In Level during the term, the investor receives 100% of principal at maturity.

Because the potential is typically higher for a Multi-Stock to fall below the Knock-In level than a single-stock Reverse Convertible, the issuer normally offers the investor a higher coupon and/or more downside protection than what a Single-Stock Reverse Convertible would provide. As is the case with the Single-Stock structure, the maximum return on Multi-Stock Reverse Convertibles is the principal plus the coupon payment. The investor does not participate in any appreciation of the underlying stocks. The coupon is paid in full under all circumstances.

May Be Suitable for Investors Who Are:

  • Willing to accept the risk of possibly owning at maturity the underlying stock whose value is less than their initial investment.
  • Looking for a potentially higher interest rate.
  • Knowledgeable concerning how options work and comfortable with investing in securities incorporating options.
  • Seeking to diversify their investment portfolio.

Important Features

  • Coupon: May provide a coupon rate higher than that of a comparably-rated traditional corporate bond of the same maturity. Typically between 8%-30% per year; the more volatile the stock, the more likely the coupon will be higher.
  • Interest payments: Regardless of the performance of the underlying stock, the stated amount of interest is paid, usually on a monthly basis, subject to the creditworthiness of the issuer and its ability to repay its obligations
  • Short-term maturity: Three-month, six-month, or one year.
  • Low minimum investment: $1000 minimum initial purchase; $1000 increments thereafter.
  • High credit quality: Typical issues are from banks with a credit rating that is investment grade or better, although credit quality should not be the sole basis for an investor’s decision.
  • Not principal-protected: If stock is delivered in lieu of cash upon maturity, it will have lost some or all of its original value.
  • Contingent downside protection: Provided by a “knock-in” feature. The Knock-In feature provides the investor with a certain amount of downside protection. The Knock-In level (also called the downside barrier) is set at a predetermined percentage of the initial share price. This downside cushion helps to protect against the daily fluctuation of the underlying share price.

Considerations & Risks

  • Principal at Risk: Purchase of a Reverse Convertible Security carries with it the risk of loss of some or all of the initial investment (the principal). By purchasing the Reverse Convertible Security, the investor also indirectly sells the issuer a put option, which is the right for the issuer to deliver the underlying stock to the investor at maturity; that stock will have lost some or all of its value since the original strike price was established. The purchaser of a Reverse Convertible Security should be financially capable of withstanding a loss, should understand how the option works and should be comfortable with the potential to receive stock worth less than the initial investment (the principal) instead of cash at maturity.
  • Liquidity: Reverse Convertible Securities are designed to be held to maturity, although investors are not required to do so. There is a liquidity risk when selling prior to maturity. Most issuers intend to provide a secondary market but they are under no obligation to do so. Some issuers post secondary pricing on their websites during market hours, where pricing fluctuates intraday.* When considering selling in the secondary market, the investor should contact his or her broker. Again, while secondary marketing of a Reverse Convertible Security is usually a viable option, there may not be a liquid secondary market for the security. In addition, market variables make secondary pricing unpredictable. *Noted here for informational purposes only; refer to issuer-specific materials for complete details.
  • Creditworthiness of the Issuer: In addition to evaluating the market for the underlying securities, the investor should investigate the creditworthiness of the issuer to evaluate its ability to make principal and interest payments. Although credit quality should not be the sole basis for an investor’s decision, it should be considered because it may significantly affect the investor’s principal and/or receipt of interest payments.
  • Issuer Call: There are some Reverse Convertible Securities that are issued with a call feature. This allows the issuer (not the investor) to redeem the notes before the maturity date. If the security is called, the investor may be faced with investing within a lower interest rate environment.
  • Taxes: For full information regarding the tax consequences of Reverse Convertible Securities, investors should review the prospectus or offering circular and consult with their tax advisor. Special tax treatment applies to Reverse Convertible Securities because they are comprised of two financial instruments – a debt instrument and an option. The debt portion is reported annually as income based on the coupon rate of a comparably investment grade-rated (e.g., AA or Aa3) note of the same maturity. Thus, because the Reverse Convertible pays a higher coupon than the conventional notes upon which the comparison is based, U.S. investor taxes are based on a coupon rate that is lower than the actual rate. The option component is taxed at maturity as a short-term capital gain if cash (rather than shares of the underlying stock) is received at maturity. If shares are delivered at maturity (meaning that the principal has been reduced), the option component will reduce the tax basis of the underlying shares; no taxable event occurs until the shares are sold.