The holder of a reverse convertible gives up the potential upside exposure to the underlying asset in exchange for an enhanced coupon. The holder of the product remains exposed to the downside exposure.
The enhanced coupon of the reverse convertible is paid in any case. The coupon may be paid quarterly, semi-annually or annually. Because of this, the product will always outperform its underlying asset to the downside. The product will also outperform if the asset doesn't rise by more than the coupon. Hence, the ideal market scenario for reverse convertibles is the prospect of a sideways trending market.
In its most basic form, the reverse convertible is constructed by means of a short put and a money-market placement. In most cases, the strike is placed at-the-money. More conservative products have an out-of-the-money strike, lower than the spot price of the underlying asset. The lower the strike, the lower the coupon. The payoff diagram on the right shows an at-the-money strike.
Although the name of the product may hint at convertible bonds, the potential downside of the reverse convertible clearly puts it in the same risk category than its underlying asset. Just because the product pays a coupon doesn't mean its risk is similar to that of a bond. In fact, the name "reverse convertible" does derive from convertible bonds, but it's the issuer who decides to "convert" the product or not. Of course, the issuer will choose to convert only if the market situation is favorable to him, i.e. when the underlying asset finishes its course below the strike of the embedded short put option at the maturity of the product.
For example, if the underlying asset was a stock, say IBM, and the product would pay a 10% coupon for a maturity of six months, and the strike would be placed at-the-money (100% of the stock's spot price at the time of the issue), then there would be 2 scenarios at maturity:
- IBM's price is lower than at issue: the product is redeemed in IBM shares and the holder incurs a loss if the stock has lost more than the height of the coupon (which amounts to 10% in this case).
- The stock's price is higher than at issue: the product is redeemed in cash amounting to 100% of the invested nominal.
- The coupon is paid in any case.
- Do invest in a reverse convertible if the prospect favors a sideways trending market.
- Do invest in a reverse convertible if the volatility is high or expected to fall.
- Carefully consider the level of the coupon in relation to the risk-free rate. The higher the difference, the riskier the product!
- Opt for a lower strike if you want a more conservative product.
- Don't fall into the habit of always investing in the same type of product just because it "worked" once, twice or all the time until now. Reverse convertibles often seem attractive at a first glance because of the high coupon, but just because the coupon is paid in any case doesn't mean that the investor will always make money.
- Don't always invest in products with one year maturity. The industry often offers products with this standard time period, but often a shorter one makes more sense. Besides your on forecast for the underlying asset and your target return, also consider the skew and the term structure of the options in order to choose the optimal maturity.
- In case of reverse convertibles on commodities or foreign exchange, pay close attention to the forwards. For instance, a strong contango will produce poor results if the pricing is baesd on the front month.
Main influence factors
- Volatility: the higher the volatility of the underlying asset, the higher the level of the coupon.
- Interest rate and dividend yield (for stocks): the higher either of the factors, the higher the coupon
There exists dozens of reverse convertible variants. Here's some of the most common:
- Barrier reverse convertible
- Worst-of barrier reverse convertible
- Callable reverse convertible
- Lookback reverse convertible
Reverse convertibles are one of the most popular structured products in Europe. However, it is worthwhile to ask yourself the question whether this is the right instrument for you. Does it match your risk-return profile? Can you bear the worst-case scenario? Reverse convertibles typically produce multiple small gains (that amount to the level of the coupon) for longer periods of time, which are often erased by one large loss. This happened after the internet bubble at the turn of the millennium as well as during the subprime / financial crisis of 2008 / 2009, and it is likely to happen again. So don't become overexcited after having cashed in your two first coupons without loss, but reassess the situation each time a reinvestment draws near.