Introduction
A
reverse convertible is not a
car with a messed-up
gearbox and no
roof, but rather, a
hybrid security that can behave like a
bond or like
shares, as the
issuer desires. As such, it is vaguely similar to an ordinary
convertible bond, where the choice is made by the
investor. In this node, we'll take a look at precisely what this
reverse convertible is, and why one would or would not want to buy one.
What is it?
In a
reverse convertible, the issuer has the choice to pay you back in either
cash or a certain number of shares. Now, if the value of these shares is lower than the value of the
cash, you can expect to get the
shares. If it is higher, you will probably get the
cash. As such, the seller has in effect the
option to
sell you
shares at a price equal to the value of the bond divided by the
shares price. As such, this option has an effective
strike equal to this price. It is noted that this "option" is technically a
warrant, as it is not issued by the
exchange, but rather by the issuer of the
reverse convertible.
So, what do we get back for this rather risky endeavour? Well, cash. A reverse convertible pays a very handsome coupon. This coupon is high because it is in essence the premium of the sold put warrant, plus an interest rate. For a one-year reverse convertible that has its strike close to the current level of the stock, this coupon can easily be 20% or more.
Convertibles and Exchangables
There is a technical difference between a reverse convertible and a so-called reverse exchangable. In the former case, the company whose shares or bond is the underlying will pay you. In the latter case, it is a third party, commonly a bank. In practice, convertibles and exchangables are nearly the same, with one small difference that we will dicuss when we discuss risk. Always check whether the product you want to trade is a convertible or an exchangable.
Risks
We have already discussed the great thing about the reverse convertible, namely that if everything is fine, you get a massive coupon. I'll now go into the risks.
The most obvious risk is
market risk. If the underlying
share goes down, and approaches or goes through the strike, you could lose money. There are two cushions here: the large coupon makes sure you won't lose everything, but at most 100-the coupon% of your investment. Secondly, the strike is typically a bit below the current stock level, let's say 20%.
Let's consider that situation in more detail. We have a reverse convertible that on a stock worth $10 that either pays back in 125 shares, or in $1000. The coupon is 20%. If the stock then drops 20%, or less, you get paid in cash make the full amount, say 120%. If it drops about 30%, you will get paid back in 125 shares worth $7, losing 12.5% on the stock, but making 20% on the coupon, so you are still up. The break-even point is at a share price of $6.4.
This is more of an indirect exposure. A put option has a long exposure to the dividend. As such, an increase in dividend creates buying pressure on the stock you are long, leading to a (temporary) loss. One way of looking at this is as follows: if a share goes ex-dividend, its value drops with the dividend amount. If this dividend is large, the value of the share drops a lot, pushing it closer to - or further through - the strike of the option. For your information, professionals refer to this as &Psi, that's a Greek capital letter psi.
Volatility a measure for how much a stock moves. The Black-Scholes equation teaches how to hedge an option with stocks and bonds. This hedge becomes more expensive when the stock moves a lot. As such, the market price of the option you are short goes up, and you make a (temporary) loss. Note that a higher volatility does mean a stock can move further, and hence go through the strike more easily. By the way, volatility tends to go up as a stock drops, so you can get hit twice by that.
Note that this general volatility level is the main driver of the coupon of the reverse convertible. In the example I gave above, the volatility is quite high; a more normal rate for such a reverse convertible would be between 10 and 15%.
Instead of putting your money in a reverse convertible, you could have just bought a government bond. Now, the 20% coupon is brilliant, but not if the government pays 25%. Okay, this is an extreme example, but the point remains: if the interest rises, we can expect to see some value being lost in a reverse convertible. Reverse convertibles normally run for only a short time, so this exposure normally is quite minor.
In my opinion, this is the truly nasty one of the lot, because it's not obvious. You have a contract with the issuer. As such, if the issuers goes bankrupt, you are in trouble. Now, if the issuer is the company of which you might get the shares, this is not an additional risk: you would have been given the worthless shares anyway, so there is no "extra" credit risk in addition to the market risk.
However, in case of an exchangable, you are also in trouble when the issuer fails, and in this case, that's a separate company, so it's a separate risk. For valuation purposes, this means that the interest rate that is relevant is not the risk-free rate, but rather, the rate paid by the issuer. Now, in the past, a typical issuers, such as a big bank paid nearly the risk-free rate, but nowadays, after the credit crisis, this is a lot more. Even if you consider this, you are still left with a risk that is difficult if not impossible to hedge for a private investor. Be, as such, very careful.
You might think that there also is a credit risk on the company whose shares you might get. This is true in a sense, but is in fact a special case of the market risk on the share price, and doesn't need to be taken into account twice.
Convertibles on a basket
One product that deserves a special mention is the convertible on a basket of shares. These products are almost exclusively emitted by banks, and as such are exchangables. Instead of only one underlying, the issuer can choose any of a number of shares to give back to you; it will pick the lowest-valued, of course. This is riskier than being short one put warrant, but not as risky as being short all of them. Such products are difficult to value and to hedge. As such, they offer more opportunity for the issuer to crank up the profit margin. Combined with the credit risk on the issuer, this is a pretty nasty thing.
Summary
A reverse convertible is a type of structured product that is a bond that, at the issuer's option, can be paid back in a number of shares or in cash. It can be seen as a bond combined with a put warrant. The high risk of these products is compensated by the generous coupon. A worst-case scenario here would be that your entire investment, with the exception of perhaps a few coupon payments, gets wiped out.
Disclaimer: This is not intended as investment advice. Don't take investment advice from random strangers on the Internet.