Reverse convertible securities
Encyclopedia
A reverse convertible security or reverse convertible is a short-term note linked to an underlying stock
. The security
offers a steady stream of income due to the payment of a high coupon rate. In addition, at maturity the owner will receive either 100% of the par value
or, if the stock value falls, a predetermined number of shares of the underlying stock. In the context of structured product, a reverse convertible can be linked to an equity index or a basket of indices. In such case, the capital repayment at maturity is cash settled, either 100% of principal, or less if the underlying index falls conditional on barrier is hit in the case of barrier reverse convertibles.
exposure, paid in the form of fixed coupons. Owners receive full principal back at maturity
if the Knock-in Level is not breached (which is typically 70-80% of the initial reference price). If the underlying stock falls in value, the investor will receive shares of stock which will be worth less than his original investment. The underlying stock, index or basket of equities is defined as Reference Shares. In most cases, Reverse convertibles are linked to a single stock.
You may also find inverse reverse convertibles, which are the opposite of a reverse convertible. The owner benefits as long the underlying stock does not go above a predetermined barrier. If the underlying stock breaches the barrier, the owner will receive the principal minus the percentage of the movement against him.
These are both types of structured products, which are sophisticated instruments and carry a significant risk of loss of capital.
In a low interest rate and high market volatility environment, reverse convertibles are popular as they provide much enhanced yield for the investors. By receiving enhanced coupons, investors take on the risk of losing part of the capital. Prior to the turn of the millennium (2000), reverse convertibles mostly consisted of investors shorting standard ATM put options. Investors would lose capital if at maturity the underlying fell below the initial level. To increase the protection for investors, barrier reverse convertibles were introduced whereby investors were instead shorting ATM down-and-in put options. The additional barrier event increased the protection for the investors, as the put option would not come into effect unless the (down) barrier was hit. The barrier protection feature triggered much increased reverse convertible issuances in UK in the early 2000s as well as in the European retail markets. By early 2010s, the (barrier) reverse convertibles were also among the most popular structured products in US.
While the barrier protection feature was beneficial for investors, for the issuers, managing relatively long-dated (e.g. 3~5 years) equity barrier risks were a challenge. The hedging parameters (Greeks) near the barrier could be unstable, and they might suddenly change which would lead to a massive increase in trading volume. In contrast to FX underlyings, equity underlyings for the reverse convertibles tend to have much less liquidity. The problems would become more severe when the products were issued to the mass retail market. To solve these practical problems in order to manage barrier risks more effectively, financial institutions (issuers) adopted various technologies in pricing and risk managing (barrier) reverse convertibles.
Reverse convertibles nowadays account for a large portion the structured products issued for retail and private investors. The issuances of other breeds of reverse convertibles, such as those combining a callable payoff, or a knockout clause, have also increased substantially with the ever changing market conditions.
Coupon payments are the obligation of the issuer and are paid on a monthly or quarterly basis. These instruments are sold by prospectus or offering circular, and prices on these notes are updated intra day to reflect the activity of the underlying equity. The general rule of thumb is: The higher the coupon payment, the greater likelihood of receiving stock at maturity.
Note: Whether or not the knock-in level is breached, the investor will receive fixed periodic coupons through the term of the notes.
and/or the internet. Pricing fluctuates intraday. Reverse Convertibles are registered with the U.S. Securities and Exchange Commission (SEC).
obligation of the issuer, not the reference company, thus they carry the rating of the issuer. The creditworthiness of the issuer does not affect or enhance the likely performance of the investment other than the ability of the issuer to meet its obligations.
. At maturity, the option component is taxed as a short-term capital gain
if the investor receives the cash settlement. In the case of physical delivery, the option component will reduce the tax basis of the Reference Shares delivered to their accounts.
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
. The security
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
offers a steady stream of income due to the payment of a high coupon rate. In addition, at maturity the owner will receive either 100% of the par value
Par value
Par value, in finance and accounting, means stated value or face value. From this comes the expressions at par , over par and under par ....
or, if the stock value falls, a predetermined number of shares of the underlying stock. In the context of structured product, a reverse convertible can be linked to an equity index or a basket of indices. In such case, the capital repayment at maturity is cash settled, either 100% of principal, or less if the underlying index falls conditional on barrier is hit in the case of barrier reverse convertibles.
Features
These are short-term coupon bearing notes, which are designed to provide an enhanced yield while maintaining certain equity-like risks. Their investment value is derived from the underlying equityEquity (finance)
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
exposure, paid in the form of fixed coupons. Owners receive full principal back at maturity
Maturity (finance)
In finance, maturity or maturity date refers to the final payment date of a loan or other financial instrument, at which point the principal is due to be paid....
if the Knock-in Level is not breached (which is typically 70-80% of the initial reference price). If the underlying stock falls in value, the investor will receive shares of stock which will be worth less than his original investment. The underlying stock, index or basket of equities is defined as Reference Shares. In most cases, Reverse convertibles are linked to a single stock.
You may also find inverse reverse convertibles, which are the opposite of a reverse convertible. The owner benefits as long the underlying stock does not go above a predetermined barrier. If the underlying stock breaches the barrier, the owner will receive the principal minus the percentage of the movement against him.
These are both types of structured products, which are sophisticated instruments and carry a significant risk of loss of capital.
In a low interest rate and high market volatility environment, reverse convertibles are popular as they provide much enhanced yield for the investors. By receiving enhanced coupons, investors take on the risk of losing part of the capital. Prior to the turn of the millennium (2000), reverse convertibles mostly consisted of investors shorting standard ATM put options. Investors would lose capital if at maturity the underlying fell below the initial level. To increase the protection for investors, barrier reverse convertibles were introduced whereby investors were instead shorting ATM down-and-in put options. The additional barrier event increased the protection for the investors, as the put option would not come into effect unless the (down) barrier was hit. The barrier protection feature triggered much increased reverse convertible issuances in UK in the early 2000s as well as in the European retail markets. By early 2010s, the (barrier) reverse convertibles were also among the most popular structured products in US.
While the barrier protection feature was beneficial for investors, for the issuers, managing relatively long-dated (e.g. 3~5 years) equity barrier risks were a challenge. The hedging parameters (Greeks) near the barrier could be unstable, and they might suddenly change which would lead to a massive increase in trading volume. In contrast to FX underlyings, equity underlyings for the reverse convertibles tend to have much less liquidity. The problems would become more severe when the products were issued to the mass retail market. To solve these practical problems in order to manage barrier risks more effectively, financial institutions (issuers) adopted various technologies in pricing and risk managing (barrier) reverse convertibles.
Reverse convertibles nowadays account for a large portion the structured products issued for retail and private investors. The issuances of other breeds of reverse convertibles, such as those combining a callable payoff, or a knockout clause, have also increased substantially with the ever changing market conditions.
Reference shares
- Underlying stocks or basket of equities may include names such as:
- Dell
- Wal-Mart
- Exxon Mobil
- Cisco
- Best Buy
- Corning
- Broad market indices may include names such as:
- S&P-500 Index
- EURO STOXX-50 Index
- FTSE-100 Index
- NIKKEI-225
- Nasdaq-100 Index
How do reverse convertibles work?
They are short-term investments, typically with a one year maturity. At maturity, the owner receives either 100% of their original investment or a predetermined number of shares of the underlying stock, in addition to the stated coupon payment. The owner's earning potential is limited to the security’s stated coupon, because he receives coupon payments regardless of the performance of the underlying reference shares. Risk potential is the same as for the underlying security, less the coupon payment.Coupon payments are the obligation of the issuer and are paid on a monthly or quarterly basis. These instruments are sold by prospectus or offering circular, and prices on these notes are updated intra day to reflect the activity of the underlying equity. The general rule of thumb is: The higher the coupon payment, the greater likelihood of receiving stock at maturity.
Note: Whether or not the knock-in level is breached, the investor will receive fixed periodic coupons through the term of the notes.
Delivery at maturity
At maturity, there are two possible outcomes:- Cash Delivery: If the stock closes at or above the initial share price upon valuation date, regardless of whether the stock closed below the knock-in level during the holding period, or if the stock closes below the initial share price, but has never closed below the knock-in level.
- Physical Delivery: If the underlying shares closed below the knock-in level at any time during the holding period and does not trade back up above the initial share price on valuation date (four days prior to maturity).
Physical delivery
The initial share price is determined on the trade date. The final valuation of the shares is based on the closing price of the reference shares determined four days prior to maturity. If the investor is delivered physical shares, their value will be less than the initial investment.Scenario 1 - cash delivery
| Reference share closing price is above the initial share price of the note on valuation date (four days prior to maturity), regardless of whether the stock closed below the knock-in level. Investor receives "Cash Delivery Amount" (Par), at maturity. |
Scenario 2 - cash delivery
| Reference share closing price is below the initial share price of the note on valuation date (four days prior to maturity), but never closed below the knock-in level. Investor receives "Cash Delivery Amount" (Par) at maturity. |
Scenario 3 - physical delivery
| Reference share closing price is below the initial price of the note at valuation date (four days prior to maturity), and has closed below the downside knock-in level during the holding period. Investors receive "Physical Delivery Amount", or shares of stock, at maturity. Predetermined number of shares delivered to the investor if closing price of reference shares below initial price. Physical Delivery Amount = (Original Investment Amount / Initial Price of Underlying Asset). |
Liquidity
These are generally created as a buy and hold investment, but issuers typically provide liquidity in the secondary market. The secondary market price may not immediately reflect changes in the underlying security. Liquidations prior to maturity may be less than the initial principal amount invested.Trading
They trade flat and accrue on a 30/360 or actual/365 basis. End of day pricing is posted on Bloomberg L.P.Bloomberg L.P.
Bloomberg L.P. is an American privately held financial software, media, and data company. Bloomberg makes up one third of the $16 billion global financial data market with estimated revenue of $6.9 billion. Bloomberg L.P...
and/or the internet. Pricing fluctuates intraday. Reverse Convertibles are registered with the U.S. Securities and Exchange Commission (SEC).
Ratings
These are an unsecured debtUnsecured debt
In finance, unsecured debt refers to any type of debt or general obligation that is not collateralised by a lien on specific assets of the borrower in the case of a bankruptcy or liquidation or failure to meet the terms for repayment....
obligation of the issuer, not the reference company, thus they carry the rating of the issuer. The creditworthiness of the issuer does not affect or enhance the likely performance of the investment other than the ability of the issuer to meet its obligations.
Taxes
For tax purposes Reverse convertible notes are considered to have two components: a debt portion and a put optionPut option
A put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
. At maturity, the option component is taxed as a short-term capital gain
Capital gain
A capital gain is a profit that results from investments into a capital asset, such as stocks, bonds or real estate, which exceeds the purchase price. It is the difference between a higher selling price and a lower purchase price, resulting in a financial gain for the investor...
if the investor receives the cash settlement. In the case of physical delivery, the option component will reduce the tax basis of the Reference Shares delivered to their accounts.
Investor benefits
These securities can offer enhanced yield and current income at the cost of higher risk. They also carry downside protection, typically up to 10-30% on most Reverse Convertible offerings. The bid-ask spread is typically 1%.Risk to consider
- The price of the reference shares may decline during the term of the note, which will affect the investor negatively, while the investor does not have the same price appreciation potential as the reference shares, because at maturity the most the investor will receive is his original principal amount.
- Investors selling notes prior to maturity may receive a market price which may be higher or lower than par value, not necessarily reflecting any increase or decrease in the market price of the underlying equity.
- Reverse convertibles do not guarantee return of principal at maturity.
- The market price of the Reverse convertibles may be influenced by unpredictable market factors.
See also
- Convertible bondConvertible bondIn finance, a convertible note is a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with debt- and equity-like features...
- Convertible securityConvertible securityA convertible security is a security that can be converted into another security. Most convertible securities are bonds or preferred stocks that pay regular quarterly interest and can be converted into shares of common stock if the stock price appreciates to a predetermined...
- Exchangeable bondExchangeable bondExchangeable bond is a type of hybrid security consisting of a straight bond and an embedded option to exchange the bond for the stock of a company other than the issuer at some future date and under prescribed conditions. An exchangeable bond is different from a convertible bond...
- Structured productStructured productIn finance, a structured product, also known as a market linked investment, is generally a pre-packaged investment strategy based on derivatives, such as a single security, a basket of securities, options, indices, commodities, debt issuance and/or foreign currencies, and to a lesser extent, swaps...