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Reverse Convertible

Category — Structured Products
By Nikita Bundzen Head of North America Fixed Income Department
Updated January 17, 2025

What is a Reverse Convertible?

A reverse convertible note (RCN), also known as a reverse exchangeable security, is a type of structured product, typically in the form of a high-yield, short-term note issued by a large financial institution such as a bank. The performance of a reverse convertible bond is linked to the performance of an unrelated reference asset—usually a single stock, stock index, or a combination of assets.

Unlike traditional corporate bonds, reverse convertible notes offer higher yields, often surpassing those of high-yield bonds. The annualized coupon rate of a reverse convertible note can exceed 25%, making it an attractive choice for investors seeking high returns.

/></p> <h2>Reverse Convertibles Explained</h2> <p>In its basic form, a reverse convertible bond typically has two embedded components that create its unique payoff structure. The first component is a debt instrument that pays a fixed, above-market periodic coupon, usually on a monthly or quarterly basis. The second component is a derivative, specifically a call option, that gives the issuer the right to repay the principal to the investor with a predetermined number of the underlying securities if the price of the reference asset dips below a predetermined knock-in level, which is often set between 20 and 30 percent below the initial price.</p> <p>Some reverse convertible notes depend on the performance of multiple reference assets or provide some exposure to capital appreciation. When you buy reverse convertible bonds, you receive higher coupon payments during the life of the note in exchange for effectively selling the issuer a put option on the reference asset. Generally, the higher the expected volatility of the reference asset, the higher the fixed coupon or interest payment.</p> <h2>How Payouts Are Determined</h2> <p>Upon maturity of an RCN, the investor receives either a full reimbursement of the original investment or a predetermined number of shares of the stock that is the underlying asset for the reverse convertible bond. The number of shares is calculated by dividing the investor’s original investment amount by the initial price of the stock.</p> <p>Investors benefit from a reverse convertible if the value of the reference asset remains stable or increases modestly. In the best-case scenario, if the value of the reference asset does not decline or stays above the knock-in level, you receive high coupon payments and the full bond principal amount in cash. However, if the value of the reference asset falls below the knock-in level, the issuer may repay your principal in the form of depreciated shares, potentially resulting in a loss of principal. This loss is partially offset by the coupon payments received.</p> <p>Reverse convertible securities are traded in the secondary market, and their pricing fluctuates intraday. In the US, the Financial Industry Regulatory Authority and the Securities and Exchange Commission regulate investments in these securities. It is crucial for investors to understand the risks involved and seek investment advice before making an investment decision, as reverse convertible securities carry more risk than traditional fixed-income investments. The principal and interest payments depend on the performance of the underlying shares, and there is a potential for loss if the stock's price declines significantly.</p> <p> </p> <h2><strong>Structures of Reverse Convertibles</strong></h2> <ul> <li> <p><strong>Basic Structure.</strong> In the basic structure, the investor will receive 100% of their original investment back if the reverse convertible note’s underlying stock closes at or above its initial price. The investor receives payment in the form of stock shares if the stock closes below its initial price, meaning the investor does not get a full refund on their initial investment. This structure offers no downside protection, so the investor assumes additional risk based on the stock price performance.</p> </li> <li> <p><strong>Knock-In Structure.</strong> The knock-in structure for a reverse convertible note involves principles similar to the basic structure but includes an element of downside protection. For example, if an investor makes a $20,000 reverse convertible note investment that includes a 70% knock-in level, this level acts as a protective barrier. If the initial price of the reverse convertible note’s underlying stock is $60, and the stock’s price at the note's maturity is higher than the $42 knock-in price, the investor will receive their initial $20,000 investment back. However, if the stock falls below the knock-in price during the RCN's lifetime, the investor will receive equity shares instead of cash. For example, in our case, the investor would receive approximately 333 shares ($20,000 ÷ $60).</p> </li> </ul> <h2>Risks</h2> <ol> <li> <p><strong>Principal Loss</strong>. If the price of the underlying asset falls below the threshold level, the investor will not be able to recover the principal amount in full.</p> </li> <li> <p><strong>Limited Return</strong>. You do not participate in any increase in the underlying asset's value above the initial price, so your total return is limited to the stated coupon interest rate.</p> </li> <li> <p><strong>Credit Risk</strong>. You are relying on the issuing company's ability to service interest payments during the note term and pay you the principal payment at maturity.</p> </li> <li> <p><strong>Limited Secondary Market</strong>. Investors should be willing to accept the risk of holding the RCN until maturity. The investment firm that issued the RCN will usually try to maintain a secondary market, but this is not guaranteed. You may get less than your original cost if you sell the security.</p> </li> <li> <p><strong>Tax Implications</strong>. Because RCNs consist of two parts, a debt instrument, and a call option, your return could be subject to capital gains tax and ordinary income tax.</p> </li> </ol> </div> <div class=

FAQ

  • What is the difference between reverse convertible bonds and convertible bonds?

    Reverse convertible bonds provide high coupon payments but imply the conversion into underlying equity shares only if the stock price falls below a predetermined level. Convertible bonds, on the other hand, allow the investor to convert the bond into a predetermined number of the issuing company's stock shares at his option, offering potential upside appreciation if the stock's price increases.

  • Do reverse convertible bonds involve risk?

    Yes, when buying a reverse convertible bond, you risk losing part or all of your principal if the price of the underlying stock falls below the knock-in price at maturity. Additionally, you do not participate in any upside appreciation of the underlying stock beyond receiving the high coupon payments.

  • Are reverse convertible securities long-term?

    No, reverse convertible securities are typically short-term investments, often maturing within a year or two. They are designed to provide high coupon payments over a short duration, with the risk tied to the underlying stock's performance.

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