Reverse convertible bonds are short-term bonds that convert into stock if a company’s share price plummets. In effect, an investor who buys a reverse convertible is selling the equivalent of a put option—the right to sell a company’s stock at a certain price. Investors also take on credit risk because the notes are unsecured debt.
Banks market reverse convertibles, as the products are known, as short-term bonds that have a safety net because they convert into stock if a company’s share price drops.They are part of the recent boom in structured notes, or bonds packaged with derivatives whose values are derived from other assets that could include stocks, bonds, currencies and commodities, or even from events such as changes in interest rates.
Bloomberg BusinessWeek recently reported that banks sold more than $6 billion worth of bonds linked to the performance of stocks in 2010, promising returns of as much as 64 percent at a time when interest rates were at historic lows.
But instead of delivering such extraordinary gains, reverse convertibles lost 1 percent on average in the first 11 months of 2010, according to data compiled by Bloomberg. The Standard & Poor’s 500 stock index, on the other hand, returned 8 percent during that period, and corporate bonds gained 11.1 percent, including reinvested interest, Bank of America Merrill Lynch (BAC) index data show.
According to MarketWatch.com columnist Chuck Jaffe, reverse convertible investors are getting the stock’s downside risk, without capturing any upside potential: The stock could triple, and you’re no richer, he says. But if it craters, you get hammered.
So why are they so popular? Some analysts suggest buyers aren’t doing enough homework to sufficiently understand the risks. And banks have a built-in incentive to sell reverse convertibles, as their fees are collected every three months.
Another reason to stay away: High fees. Banks typically charged 1.6 percent on a three- month reverse convertible, or about 6 percent annualized, according to ConsumerAffairs.com. In comparison, the average annual fee on stock mutual funds is 1 percent.
The lesson here is an old one: If an investment pitch sounds too good to be true, it probably is.
A version of this story also appears as a WEALTH magazine podcast.
Tags: bonds, fees, INVESTING, reverse convertible, stocks