Reverse Convertible Bonds are a type of structured bonds with unsecured capital which ensure, to the holder, a high return, often higher than average market yields at the same maturity. They are characterized by always having a short-term maturity and are generally issued at par. This high yield, however, is due to a particular combination of a short-term ordinary bond (with a duration of less than one year) and a put option implicitly sold by the subscriber to the issuer. Therefore, the optional component present on these securities makes them a riskier investment than an ordinary bond and therefore justifies this greater risk with a high yield differential.
In fact, the holder of a Reverse Convertible Bond will be entitled to receive a higher coupon compared to bonds of comparable duration, but at the same time, they take the risk of not receiving the entire capital invested initially. In fact, the security will be linked to an underlying (generally a listed share, a stock index or even a basket of indices) and instead of the return of this underlying asset it will repay 100% of the capital invested initially or a lower amount of cash in a number of equivalent shares.
In practice, once subscribed, a Reverse Convertible Bond will always guarantee a high coupon, but will never guarantee full repayment of the principal. The subscribed capital will be fully reimbursed only if the stock or index is above a certain level called the "strike price". In this case the investment will prove to be very profitable: the investor will receive the invested capital and an excellent return on it. However, in the event that this underlying is lower than the aforementioned strike price, the repayment of the capital will take place by delivering a predetermined number of underlying shares (or by paying their equivalent) of a value lower than the nominal value of the bond.
The implicit put option can also be of the “knock-in” type. In this case, the delivery of the shares is subject to two conditions: the share price is below the strike price and the price level is exceeded downwards, at least once during the life of the bond.
Normally, the Knock-in clause indicates a percentage of devaluation - which generally varies between 15% and 30% - of the minimum conversion price that must be reached for the issuer to repay the loan by delivering shares. Reverse Convertible Bond Example
Advantages of a Reverse Convertible Bond
• High yield on a short-term maturity, typically much higher than market yields.
• Possibility of having a downside protection (typically up to 10-30%).
Disadvantages of a Reverse Convertible Bond
• High risk factor;
• Investment with unsecured capital, therefore the repayment of the subscribed capital is not certain;
• Possibility of receiving equity securities at maturity whose market value may be much lower than the initial investment, but no possibility of receiving shares with a value greater than the capital invested (which is established upon signing the contract).
• Investors who sell securities before maturity may receive a market price that may be above or below par, not necessarily reflecting an increase or decrease in the market price of the underlying stock.
• The market price of reverse convertibles can be affected by unpredictable market factors.
• If the underlying security issues a special dividend not previously announced and the security were to be exchanged ex-dividend prior to the expiration of the reverse convertible, it is possible that an investor in the structure could suffer a principal loss as they are not eligible to receive the special dividend.
Reverse Convertibles today represent a substantial share of structured products issued to private and retail investors. Issues of other types of Reverse Convertibles, such as those that combine a callable payoff or a knockout clause, have also increased substantially with changing market conditions, becoming an increasingly used and common instrument.
Finally, since it is an unsecured debt obligation of the issuer, the issuer’s rating will always be valid. In any case, the greater or lesser creditworthiness of the issuer does not improve the return on the investment or the performance of the underlying, indicating only the issuer’s ability to fulfill its obligations.
Generic market indices to which it can refer
Having said that the Reverse Convertibles Bonds can be linked to different types of listed shares, indices or baskets of indices, the most common (among the indices) are the following.
• Standard & Poor’s 500 Index;
• EURO STOXX-50 index;
• NIKKEI-225 index;
• Nasdaq-100 Index;
• FTSE-100 Index;
• RSI Diversified Index;