Personal Investment Notes

I never heard of these type of investments until recently…probably because the yields on traditional debt instruments are low and investors want to make up their stock market losses quickly. On the surface, the reverse convertible security looks like a good investment.

Reverse convertibles are unsecured — and sometimes unregistered — short-term notes, typically with a duration lasting six months to two years, linked to the price of an underlying stock or stock market index. These securities are created by underwriters, such as Merrill Lynch, not the underlying stock company.

Effectively, you’re combining a debt instrument and a put option, selling the issuer the right to give you the underlying stock at some point in the future.
During the holding period, the security has a high coupon rate; double-digits are the current norm, peaking in the neighborhood of 25%. (Many reverse convertibles have a minimum initial investment of $1,000, part of their appeal to small investors.)
When the security matures, the investor gets the big interest payment plus either the return of their original investment or a predetermined number of shares in the underlying stock. There are two different structures for determining how the payoff works, but here’s the plain English on the possible outcomes:

1. If the price of the underlying stock goes up, you get back the interest payment and your cash.
OR
2. If the stock declines in price – or trades for a single day below a specified “knock-in point” — you get the promised interest payment, plus the shares. Since the shares have lost value since you entered the deal, you lose a corresponding amount of principal, even if you turn right around and dump the shares for cash.

Here’s an example: You buy a $10,000 one-year reverse convertible linked to XYZ stock, which is trading at $10, and has a 15% coupon rate. The deal has a “knock-in price” of $7 per share, giving you more downside protection than in a basic reverse-convertible deal.

If XYZ is up at the end of the year, you get back your 10 grand, plus $1,500 in interest but no stock.

If XYZ *never* falls below the knock-in price, (though it may be down for the year) you get back 10 grand plus $1,500 in interest but no stock.

But if XYZ is worth less than $10 per share at maturity and the stock closed at least one day below $7, you’ve been “knocked in” to trouble.
You’ll get the $1,500 coupon payment in cash, plus 1,000 shares of XYZ (your $10,000 divided by the “reference price” at time of purchase). So, if XYZ is trading at $8.50 per share at maturity and once crossed the $7 line, you finish the year with the same $10,000 you started with; if the stock ends the period at $6 per share, you’re getting back cash and securities totaling $7,500.
(And as an added kick in the pants, the two-investments-in-one structure means that anyone who gets stock back on these deals is subject to what accountants like to call “special tax treatment.” If you’re not big on the Internal Revenue Service’s brand of “special,” check with your tax preparer before considering this kind of deal.)
In short, you are getting the stock’s downside risk, without capturing any upside potential; the stock could triple, and you’re no richer, but if it craters, you get hammered. Ask investors in some widely issued reverse convertibles backed by Countrywide Financial stock how good that felt.
The sellers of these products say they are right for people looking for higher rates of return than are available on conventional notes, who don’t mind the risk of the underlying stock, who are comfortable with options and are looking for ways to diversify their portfolio.

Summary

Note that you *always* receive the income at the stated coupon rate.
You will get back either your principle or shares of the underlying stock.

Expenses

The arrangers’ fees and commission of around 5 per cent are baked into the pricing of these instruments, just like in a front-end load mutual fund. Pretty high, but maybe easier than dealing in options directly.