Comparatively little is written about reverse convertible securities. Many investors have never heard of them. While underpublicized, they represent an interesting buy-and-hold investment option for the sophisticated investor.
What are they? Reverse convertible securities are short-term coupon-bearing notes, typically with six months to two years until maturity. They’re debt instruments with put options, often featuring remarkably high yields.
How do they work? Well, let’s compare and contrast. A standard convertible bond is linked to an underlying stock, and it gives you what is essentially a “call option”, you, the bondholder, have the chance to convert the principal of that bond to another type of debt or equity at a set time and price and for a set number of shares. If the stock underlying the bond isn’t performing well enough to warrant such a conversion, the option obviously loses value. As a consolation, you still have a security in your portfolio that will pay face value plus interest at maturity.
When you buy a reverse convertible, you are essentially selling a “put” option on the underlying stock. If the stock performs up to expectations, the notes pay you regular interest (sometimes double-digit yields), and you get your full original investment back in cash when the bond matures. The downside is, if the share price of that stock dips below a certain level, you are obligated to buy that stock instead of getting cash and interest at maturity. So goes the promise and risk of the reverse convertible.
The appeal in a flat market. The interest on reverse convertibles is often quite impressive – from 7% up to 25% or higher, to cite one recent survey, which also noted that sales of these notes jumped 81% during 2007. With coupons like that, it is no wonder that these investments attract attention, especially among investors seeking income.
Should you consider the reverse convertible? Obviously, reverse convertibles are not for every investor. They are usually linked to a single stock, and we all know stocks can be volatile as well as promising. (Occasionally, a reverse convertible will be linked to an index or a basket of equities.) So you must invest in them carefully. If the income potential of reverse convertibles intrigues you, then you should talk to a qualified financial advisor with knowledge of these short-term investments.