A year ago, a Wall Street Journal article warned about the risk of investing in “reversible convertibles.” Now, these risks have become a reality for many investors, who have experienced substantial losses due to these products.
It began with Wall Street tempting investors who were hungry to make money with these risky complex securities while boasting of their potentially extravagant yields. These securities, which are usually linked to a single stock’s performance, can result in yields of 7% to 25% or greater.
In the past couple of years, sales of these notes soared, while yields for numerous fixed-income investments dropped. For example, in 2007, Arete Consulting LLC reported that small US investors purchased about $8.5 billion in reverse convertibles-an 81% increase from the year prior.
Morgan Stanley, ABM AMro Holding NV, and Barclays PLC are among the firms that have issued reverse convertibles, while firms including Wells Fargo and others were also active in the sales of these securities. These products are supposed to offer small investors a high level of income in return for a minimal investment. However, if the stocks drop dramatically, investors can lose most of their investment-especially if they didn’t take part in any of the underlying stock’s gains.
A reverse convertible is usually sold in notes of $1,000 increments that provide regular interest payments during the investment term. Upon the maturity of the note, an investor will receive their full original investment back in cash-except when certain conditions tied to a set “barrier” level apply.
However, if the underlying stock price drops under that level during the note’s term and finishes under the initial stock price, the investor doesn’t get cash and instead receives beaten down stock shares. This can be very dangerous for investors when reverse convertibles are linked to stock shares.
Reverse convertible buyers, who are selling a “put” option on the underlying stock, are obligated to purchase the shares if they go below a certain amount. The more high risk the stock, the greater the put option, and the higher the yield that investors can get paid.
Reverse convertibles also come with other challenges. An investor who tries selling a reverse convertible before it matures may have problems recovering his or her original investment.
In 2007, the Financial Industry Regulatory Authority sent inquiries to structured providers about their sales and marketing practices. Regulators wanted issuers to better monitor how they market reverse convertibles to small investors.
Issuers stand to gain financially from selling this product, which usually come with substantial fees (generally in the 2% or 3% range) and are priced into the yield that investors are getting. The issuer’s profit will depend on how it hedges against the risk of issuing the note.
Brokerage firms have been known to compare reverse convertibles to investments that are typically safer. FISN INC. lists reverse convertibles on its Web site under “CD Alternatives”-even though CD’s come with a lot less risk. The NASD, in 2005, recommended limiting the sale of structured products to investors who have options trading approval. Yet even sophisticated investors can run into problems with reverse convertibles.
With the markets becoming more volatile, the March 2008 WSJ article warned that circumstances could get “rougher”. Yet at that time last year, issuers were still claiming that even with the risks, reverse convertibles were still a good bet for investors.
Reverse convertibles have left investors with beaten-down shares. For example, investors who purchased reverse convertibles linked to Countrywide Financial Corp. (whose share prices sank over 70%) lost over 50% of their money by the time the notes matured.
Related Web Resources:
Risky Strategy Lures Investors Seeking Yield, The Wall Street Journal, March 28, 2008
Reverse Convertibles Can Turn The Tide On Investor Returns, Investopedia Continue reading