Is Now The Time For Reverse Convertible Notes?

Reverse Convertible Notes diagram

Estimated reading time: 8 minutes

Reverse convertible notes, or RCNs, are structured investment products with a short-term that can be an attractive option when stock markets are sluggish and when low-interest rates or yields make bonds and other products less profitable.

RCNs deliver reliable income streams that often outperform conventional investment products, including higher-yield bonds, considered one of the more risk-averse options.

However, an RCN has a greater risk element to consider. While RCNs are similar to stocks and bonds, with the option to sell the asset at a specified price through a put option, there are an equal number of downsides. Investors must fully understand the product profile before putting any capital at risk.

What Are Reverse Convertible Notes?

RCNs are investment products that have comparisons with bonds. Investors receive a coupon rate, calculated and paid quarterly based on a predetermined interest rate, and a final payout on maturity.

These products are normally linked to an underlying asset, usually a stock. They can mature within three to twelve months as a short-term investment that provides advantageous returns.

Well-known banks and financial institutions issue most RCNs. Still, the associated stocks linked to the RCN impact the return value without any influence or involvement from the company itself.

There are two elements to an RCN – the put option, permitting the holder to sell the note through a derivative instrument with a fixed date and value. The other aspect is a debt instrument issued like a bond to raise capital.

Reverse Convertible Note Returns

During the lifespan of an RCN, the issuer pays the holder the coupon rate, which varies depending on the nature of the stock and the associated price volatility. Higher-risk stocks also carry a higher put option valuation and, therefore, a better coupon rate – more risk equals more reward.

When the RCN hits maturity, the investor either receives back their invested capital, with the coupon rate acting as the return, or equity stocks, calculated by comparing the original stock value with the invested amount.

Two RCN structures determine the relevant pay-back system:

  • Basic structure RCNs return the original capital at maturity, provided the stock closes on par or is higher than the initial price. If the stock falls, the investor receives shares based on the opening values – those shares will consequently be valued at lower than the invested capital.
  • A knock-in structure means that the investor receives either the return of their capital or the calculated number of shares but has downside protection built into the product.

Downside protection safeguards the original capital value and mitigates the risk that the investor will receive back less than they invested or shares valued lower than the initial capital.

Reverse Convertible Note Example

For our example, the RCN has a barrier of 80 per cent, also known as the knock-in level, and the following terms:

  • £13,000 capital investment
  • Stock valuation of £65

The 80 per cent barrier means that, provided the stock does not close at £52 or lower (at 80 per cent of the original valuation) and is above £52 at maturity, your initial capital of £13,000 will be protected.

When the RCN term ends, if the stock is lower than £65, the opening value, the capital converts into a predetermined number of shares, based on £13,000 capital divided by £65, allocating you 200 shares.

However, those 200 shares are now worth £52 each, which means your real-terms return is stock valued at £10,400, an effective £2,600 loss. The options here would be to sell the stocks and accept the loss or retain them with a view to selling once the share prices rise.

If the same stocks close at a higher value than £65, the initial £13,000 capital is returned, even if, at some stage during the term, the shares had dipped below the £52 barrier.

Reverse Convertible Note Risks

Every investment involves risk, and RCNs are no exception. You can potentially lose your principal when the product matures or receive only part of the invested value back.

While investors receive the coupon rate, they are not actively participating in the underlying stock when the valuation increases above the opening price. Therefore, the total potential return is restricted to the coupon interest rate.

Other inherent risks include credit risk, where you rely on the issuer to remain solvent and honour interest payments owing throughout the term. There is a slim but real possibility that an issuer could become insolvent and not return capital owing.

RCNs also have a limited secondary market, with the general objective of retaining the RCN until you reach the maturity date. There may be opportunities to sell an RCN through a put option, but this isn’t necessarily guaranteed.

Sometimes, RCNs have additional product features, such as a call provision. This feature is detrimental to investors and could mean having your RCN removed just as it begins to produce favourable yields.

It is also important to budget for tax exposure since returns on RCNs are normally taxable.

The Pros And Cons Of Reverse Convertible Notes

RCNs can provide higher returns and ongoing interest income, with rates above those normally available on conventional fixed-return products, provided you are happy to accept the risk exposure and the potential to lose some or all of your capital.

The essential factor is to research and track the underlying asset and have confidence that it will not fall underneath the threshold knock-in level and begin generating a loss. Financial institutions that offer RCNs are normally basing their product terms on the expectation that market values will drop or that the stock is sufficiently unstable to make this a potential outcome.

However, the advantages are clear, with the possibility of investing a relatively small capital balance and receiving yields in the double digits over the duration of between one quarter and one year.

Reverse Convertible Notes FAQ

What are the main factors that impact the returns available from reverse convertible notes?

RCNs are linked to an underlying stock asset, so the more volatile the stock asset, the higher the coupon rate – but the greater the chance of making a loss. Where stocks have either a higher dividend yield or a higher interest rate, the higher the coupon will also be.

How should novice investors use reverse convertible notes?

Investors are normally best advised to use RCNs if they are trading in a sideways-moving market or where current volatility is fairly high but is expected to stabilise.

Newer investors should carefully analyse the coupon rate because risk and returns are intrinsically linked. The bigger the difference between the risk-free rate and the coupon, the higher the exposure.

It is also wise to avoid reinvesting in similar RCNs linked to comparable stocks or to invest in the same alternative products multiple times – even though coupons may be high; this investment route is never guaranteed to make a return.

What are the risks linked to reverse convertible notes?

RCNs have variable risk-return profiles and should match your risk exposure appetite and broader investment portfolio, with full awareness of the worst-case scenario to allow for sufficient planning. Based on the coupon, these products normally provide multiple more modest gains, but can be overtaken instantly by one larger RCN that makes a loss.

Are there different reverse convertible note product variations?

Yes, RCNs are a product category, and there are many variants, including:
– Barrier reverse convertibles, where the holder releases potential profitable exposure to the linked asset for a higher coupon rate.
– Worst-of-barrier reverse convertibles, sold in the US with security in the same currency linked to the underlying basket of indices.
– Call-back reverse convertibles, with a quarterly coupon and options to convert into shares at specific times during the product term.

What are the payoff features of reverse convertible notes?

While RCNs sound like a type of convertible bond, they are different because the exposure to the downside means the risk associated is comparable to that of the linked stock asset. Even though the investor receives a coupon, the issuer chooses whether to convert the product into shares or return the investor’s capital.

Issuers convert if the market position and stock valuation make it favourable for them to issue stocks valued at a rate beneath the original invested value.

For example, if an RCN has a 10 per cent coupon over six months, with a strike at 100 per cent of the stock spot price at the start date, there could be two outcomes. First, the investor receives shares at an effective loss if the stock price is under the original value at maturity.

However, if the stock price increases, the issuer redeems the RCN with a cash payout at the total value of the initial capital. Either way, the investor receives the coupon, normally paid quarterly at the pre-agreed rate.

Investors should explore all the what-if scenarios to establish the maximum possible gain and loss before making any decisions.

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