The Basics of Reverse Convertibles

Reverse convertibles are a unique type of structure product that combines both stocks and debt instruments. Investors receive coupon payments from the issuer and then at the end of the term could receive their initial principal back or a certain number of shares of stock. Here are the basics of reverse convertibles and how they work.

Reverse Convertibles

With this type of investment, a debt instrument is tied to the performance of a single stock in most cases. In some cases, it can also be tied to a particular financial index. Investors are hoping that the price of the stock does not fall below a certain level. If the price of that stock falls below a knock-in level, then they will receive a certain number of shares of the stock up on maturity of the instrument. In most cases, this type of investment is considered to be a short-term security. Generally, it will only last for approximately 1 year or less. During that year, investors will receive regular payments from the issuer based on the coupon rate of the note. Coupon rates can vary drastically from one issuer to the next. However, these coupon rates are generally very high compared to some of the other investments that you can find on the market.

Cash Delivery vs. Physical Delivery

When the security matures, there are two possible outcomes that could occur. The first outcome involves the situation in which the price of the stock traded at a price that is above the predetermined knock-in level on the valuation date of the security date. The valuation date of the security is four days before maturity. If the price of the stock trades above that level on the valuation date, the investor will receive cash. The cash will be equal to the original amount of money that was invested.

The other option is referred to as physical delivery. If the price of the stock trades below the knock-in level on the valuation date of the security, the investor will receive a certain number of shares of stock. When this happens, the shares will be worth less money than what the investor originally put into the security.

With cash delivery, the investor receives the benefit of getting regular coupon payments as well as their entire initial investment back. This makes the investment similar to a high yield corporate bond. 

Secondary Market

Reverse convertibles can be traded in the secondary market. However, they were originally designed to be an investment that the investor holds until maturity. If you need to sell this after getting involved, you should be able to find some investors who are willing to buy it in the secondary market.

Credit Ratings

When you are considering getting involved in this type of investment, you should most likely check out the credit rating of the company that issues it. This is a type of unsecured debt and you want to make sure that you are dealing with a company that is considered to be credit worry.

 

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