Over the cliff with reverse convertibles

Reverse convertibles promise income investors high returns in sideways markets. But why jump over a cliff for double digit returns?

Key Points

  • Reverse convertibles increase returns and risks
  • The risks are often disguised within complicated payoff arrangements
  • Recently, some investors have lost a significant portion of their capital

The Product

In our last Super Insights article we looked at capital protected products (CPPs). They’re safe as far as getting your money back is concerned but boring on the returns.

Reverse convertibles are the opposite. This is a supercharged, high-octane investment (try 15% a year or more) for thrill-seeking income investors, if indeed there can be such a thing.

A reverse convertible is a high yield instrument where the repayment of capital is linked to the performance of an underlying share or basket of shares.

An excellent example is the UBS Goals Plus product, last issued in June 2011. Investors paid $100 to buy a security (in the form of a DPA) paying an interest rate in the order of 12-17%pa over a 15-month term, with a ‘conditional’ capital guarantee on maturity.

And what was that condition?

The issuer repaid the $100 in full if none of a linked basket of five shares fell in value by more than 30%. If one of those five shares did suffer a fall in price of 30% or more, the repayment was reduced by the percentage fall. So if one share price fell by 40%, even if the other four rose, the investor would receive only $60 on maturity.

The equation is simple enough; get a rate at three or four times that of a term deposit but run the risk of significant erosion of capital. No wonder these products have a highly specialized, Thelma-and-Louise appeal.

The problem

If one was talking about a 30% fall in the general market before one sacrificed capital, the pitch might have its attractions. Such market falls are extremely rare. But individual stocks can fall (and rise) by 30% or more in quite rapid fashion.

For example, this time last year, JB Hi-Fi was changing hands for around $20. Now it’s selling for under $10. Between 9 Jul 11 and 3 Oct 11, Rio Tinto fell by 30% and Billabong has more than halved in less than a year.

The fact is, individual companies fall by 30% or more over a period of a year or two with surprising regularity.

The reverse convertible marketing brochures might talk of ‘diversification’ or the ‘balance’ of the portfolio of companies within the linked basket but this is to deliberately miss the point. The more companies in the basket, the greater the chance of any one of them falling through the nominated barrier.

These products are the financial market equivalent of Russian roulette: The more companies in the basket, the more bullets in the chamber.

This isn’t just a theoretical point either. Let’s return to our UBS Goals example to ram home the point.

The most recent offering included Series 14, which had an interest rate of 17.5%pa and the following stocks in the basket: Asciano (AIO), ANZ Bank (ANZ), gulp…Bluescope Steel (BSL), Fortescue (FMG) and QBE Insurance (QBE).

Chart 1 shows how these stocks have performed since the issue date.

Note how all the stocks are trading above the 30% cut-off—all except one. Since the issue of UBS Goals, Bluescope Steel has plummeted 66%. The ‘worst of’ nature of the instrument means the payment to investors will be determined by the BSL share price alone. The performance of the other four stocks is irrelevant.

How much of their principal investment will investors lose?

On August 11, about two months after issue, UBS were quoting a buy-back price of 75 cents (per dollar invested). Today, that figure has fallen to 40 cents in the dollar. In the chase for a 17.5% yield, investors are sitting on a loss of 60% of their principal.

The point of this example isn’t to single out UBS, merely to illustrate how badly these products fare when things turn against them. Reverse convertibles are a classic example of an investment that fares well most of the time but blows up your capital the day it doesn’t.

Do reverse convertibles ever stack up?

In short, no. You might get lucky once, twice or perhaps more but, as in the casino, eventually being on the wrong side of the odds catches up with you. The house wins in the end.

The money to be made from these products is in issuing and selling them, not investing in them.

Are there alternatives?

Reverse convertibles are the economic equivalent of selling ‘knock-in’ put options (an exotic option contract). The issuer sells the put options and pays a portion of the premium through to investors as the high yield on the instrument.

The alternative is to sell options yourself. But as we have warned previously, this is an extremely complex, high risk area that requires significant experience or assistance.

If you want to consider it, or simply do some research because there’s not much on telly tonight, the strategies set out in Table 1 can be used for generating premium income from options.

Strategy Description Key Risk
Table 1: Common option strategies to generate premium income
Covered calls (aka ‘buy/write’) Selling call options over portfolio of shares owned by investor. Premium income is paid to investor by buyer of options. Downside risk on share portfolio. Investor will suffer capital loss on any move below starting price and make net loss if capital loss exceeds income (dividends and premium) received by investor.
Selling put options Selling put options over specific shares or index. Premium income is paid to investor by buyer of options. Put option being ‘in the money’ for buyer due to fall in relevant share price. Investor will make net loss if exercise price is greater than share price at time of exercise.

Final thoughts

Some issuers seem to have given up on the reverse convertible. Perhaps they’re simply too damaging for their reputations when things go wrong. But they are still around and Product Sleuth will be keeping an eye out for them.

In the meantime, put them firmly in the basket of ‘high yield means high risk’ and steer clear.

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