Reverse convertible notes are short-term bonds peddled to investors by Wall Street firms. Throughout their term, they pay comparatively high interest rates, but whether they pay back the investor’s principal is the big question.
The reason for that question is because a reverse convertible’s principal repayment is linked to the performance of a specific stock or index, like Dell or the NASDAQ-100. If the price of the linked security falls below a predetermined level when the note reaches its maturity, the principal returned to investors will be less than the face value of the note. If the stock or index appreciates during the note’s term, investors do not receive any of the gains; they just get repaid their principal. On the flipside, if the linked security’s price falls, investors may only get a fraction of their principal back. Many investors learned this the hard way in 2008 and 2009 when their notes matured in the midst of a depressed stock market.
Reverse convertible notes are much more complex than traditional bonds and involve elements of derivative and options trading. There is considerably more risk than traditional fixed income instruments, and also the additional risk of the underlying security’s performance.
Put another way: reverse convertible notes are an irrational bet where investors take on the risk of stocks without the opportunity to realize their rewards.
Wall Street firms including JPMorgan, Barclays, Citigroup, Wachovia, Lehman Brothers, Ameriprise, Royal Bank of Canada, ABN Amro, and others sold $52 billion of these risky instruments. Some firms may be liable for withholding information about the risks associated with reverse convertible notes; most notably, the potential for significant losses if the value of the pegged stock falls below the trigger price.
Both the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have reportedly been investigating firms for failing to adequately disclose risks, possible conflicts of interest, and selling the notes to investors for whom their risks were unsuitable.
According to the Wall Street Journal, “the [SEC] is investigating whether Wall Street firms that developed the bonds failed to adequately disclose the risks and fees to investors before they bought the notes, according to people familiar with the situation. They also are examining the disclosure of potential conflicts of interest, such as a bank selling a note linked to the stock of a company it is advising.” Since reverse convertible notes are essentially a gamble on the future performance of an equity position, investment banking firms may be in an advantaged position against investors if the banks have insider information on that equity.
It is difficult to imagine the kind of investor who is suitable for a reverse convertible note. Investors who want the safety of bonds generally fear the stock market’s volatility, and thus are not good candidates for a product whose value is tied to stocks. Secondly, the general premise of this product is questionable at best. Investors who want the security of bonds and the growth of stocks would be wiser to simply make separate and diversified investments in stocks and bonds.
Time and again, Wall Street touts some new financial product that offers high returns with low risk. Unfortunately, that relationship does not exist. Any high yield investment is going to have significant risks, no matter how Wall Street spins it. Reverse convertibles are no exception.