Commentary: Investors' Reversal of Fortune With Reverse Convertibles
A Wolf in Sheep's Clothing
Traders Magazine Online News, August 31, 2010
Reverse exchangeable notes, or "reverse convertibles," were popular investments prior to the recent market collapse. Investors bought nearly $7 billion of these securities in 2008. But when the equity markets crashed, so did the value of many reverse convertibles. Some investors were shocked to learn that the investments sold to them as safe alternatives to bank certificates of deposit or Treasury securities actually were highly complex structured products with significant amounts of downside risk. As we now know, many brokers pitched reverse convertibles as ordinary high yield bonds and neglected to disclose the risk of loss inherent in their exchange feature. These questionable sales practices, and a slew of investor complaints, have gotten the attention of both the plaintiffs' bar and FINRA. FINRA has made reverse convertibles a priority for its enforcement division. Earlier this year, FINRA also issued an investor alert and a notice to members targeting the sale of reverse convertibles.
Reverse convertibles are a structured product comprised of an unsecured note and a put option. The put option generally gives the issuer the right to repay the principal of the note with a fixed amount of some asset--often an individual common stock--in lieu of cash, if the value of the identified asset falls below a specified price, or "knock-in" level. The knock-in level usually is set approximately 20 percent to 30 percent below the underlying asset's price at the time the reverse convertible is issued. Part of the above-market yield on reverse convertibles reflects the risk of loss of principal associated with the exchange feature. The holder of a reverse convertible does not own the asset tied to the note and is not entitled to participate in any appreciation in the value of that asset. The holder is betting that the value of the underlying asset will remain above the knock-in level, while the issuer is betting that the price will fall. If the value of the underlying asset drops below the knock-in level, the issuer can relieve itself of the full principal obligation by delivering the lower-value underlying asset, while the note-holder ends up bearing the loss.
Reverse convertibles continue to be a very popular investment among individual investors. FINRA reports that, despite a history of abusive sales practices and a somewhat dismal performance record, reverse convertibles are once again among the most popular structured products with retail investors. Bloomberg has reported that investors purchased nearly $700 million of reverse convertibles in May of this year. At that pace, sales of reverse convertibles in 2010 will outpace the staggering 2008 figure.
It is not hard to understand why reverse convertibles are such a tempting investment for individual investors. First, they offer shockingly high yields. Some reverse convertibles have been known to have yields as high as 30 percent. Moreover, some brokers continue to market reverse convertibles as relatively safe, short-term fixed income securities. These brokers downplay the risks of reverse convertibles, and fail to explain their complexities. Reverse convertibles often have complex fees and pay-out structures that can make it very difficult to accurately assess their risks, costs and value. According to FINRA, it is "all but impossible" for individual investors to determine whether reverse convertibles represent a good deal.
These securities have a checkered past and a worse looking future. A 2009 Wall Street Journal article referred to reverse convertibles as "nest-egg slashers" and "the investment that just won't die." More recently, a recent Bloomberg article called reverse convertibles "Wall Street's next bubble," and went on to note that there are hedge funds that "are being established specifically to buy this crap from distressed retail investors as and when rates start to rise." In February, FINRA fined H&R Block Financial Advisors $200,000 for failing to establish supervisory systems and procedures in connection with the sale of reverse convertibles, and it is doubtful that this will be FINRA's last enforcement action in the area.
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