Trade of the month: reverse convertibles

Volatility makes reverse convertibles popular but beware the risk

For most investors and advisers, structured products are about risk control, which explains the appeal of capital-protected notes and super-tracker products. Reverse convertibles, by contrast, are an aggressive, high-yield product that includes significant risk to capital.

Most structured products involve the purchase of an option and a zero-coupon bond, which is how capital-protected products are created, for example. The investor maintains capital protection and gives up interest in return for a possible equity return.

Reverse convertibles take a different approach. Starting with a par-yielding investment, they boost yield by selling a put option linked to an underlying (usually a stock or an index).

This provides an insight into the scenarios in which reverse convertibles are popular. The first is when interest rates are low, because then investors are tempted to boost yields in order to achieve a certain level of annual income - sometimes without regard to current market conditions. Corporate bonds or credit instruments offer one method of doing this, but that option requires a detailed analysis of the paper involved and many investors are uncomfortable in taking on full credit risk.

The second scenario that favours reverse convertibles is when volatility levels are high, in which case the premium generated from selling the put option is at its highest and will therefore deliver a large pick-up in yield.

In markets that display low interest rates and high volatility (much like the current situation), reverse convertibles can appear extremely attractive. Though capital protection is no longer present, in the minds of many investors the high headline yield is tempting in a way that even a good participation rate in a principal-protected note cannot quite match, as the expectation is always that the income level is achievable.

The popularity of reverse convertibles during periods of volatility implies a significant accompanying capital risk, however. This means careful structuring and timing is necessary when offering them because they will incur hefty capital losses in a bear market.

The products often attract the attention of regulators, which inevitably concentrate on products that have the capacity to cause sudden losses. The Financial Industry Regulatory Authority in the US is considering whether they are suitable for a retail audience, for instance. Problems usually centre around advice and disclosure, and how the products are marketed and their risks explained.

Because of the risk to capital, reverse convertibles often include features aimed at mitigating risk, the most common of which is a barrier or buffer to cushion against immediate market falls. While these can help lessen risk, they in turn reduce the yield because the barrier reduces the value of the put, thereby leaving less premium available for spending on income.

There is often a clear distinction in how reverse convertibles are structured in different markets. In the UK and Europe, the norm is to issue products linked to a market index for a horizon of between one and five years. As downside risk is moderate, the pick-up in yield is 2-5% per annum. The idea is to issue a product that offers a good chance of full return of capital unless a severe bear market ensues.

In the US, by contrast, the appetite is for short-dated products linked to single, often volatile stocks. Here, market timing and stock selection is crucial, and the realistic strategy is to make more from income to compensate for occasional capital losses. This is fine for those with the research skills and ability to diversify a portfolio, but it can be disastrous for less experienced investors.

In conclusion, reverse convertibles certainly have their place, but they must be treated very carefully.