When a sophisticated provider of financial services stands toe to toe with a naïve consumer, the all-too-predictable conclusion resembles the results of a heavyweight champion and a ninety-eight-pound weakling. The individual investor loses in a first-round knockout. (David Swensen, Unconventional Success, Free Press (August 2005), p. 341)
Whenever interest rates fall to historically low levels Wall Street’s product machines crank out complex securities that entice investors with extravagant yields, but come accompanied by great risks. Among the more alluring of products is something called a reverse convertible. Small U.S. investors snapped up $8.5 billion worth of these instruments in 2007, up 81 percent from 2006 (1). We will explore how these securities work, beginning with a definition.
Reverse convertible securities are unsecured short-term notes (generally from six months to two years) of the issuing company that are linked to the price of an underlying stock (typically not the stock of the issuer). The security comes with a high coupon rate (from 7 to as much as 25 percent). At maturity, the investor will receive the interest payment plus either 100 percent of his original investment amount or a predetermined number of shares of the underlying stock. In return for the high coupon and the credit risk of the issuer, the investor bears all the downside risk of the underlying equity (under what is known as the basic structure) or much of the downside risk (under what is known as the “knock-in” structure). However, he does not participate in any of the upside potential—the upside is limited to the interest payment. Let’s look at the risks under the two different types of structures.
In addition to accepting the credit risk of the issuer, investors accept price risk related to the underlying security. The risk shows up if at maturity the price of the linked security is below the price at issuance. Consider the case of an investor who purchases $1,000 of a one-year reverse convertible linked to the price of Intel. Assume the price of Intel was 25 at issuance and the coupon is 15 percent. If the price of Intel at maturity is 25 or greater, the investor will receive $150 in interest and the return of his principal, for a total of $1,150. However, if the price at maturity is say 10, then the investor receives $150 in interest plus 40 shares (1,000 divided by 25) of Intel, shares that are now worth just $400. Thus, the investor receives a total value of $550, losing 45 percent of his investment.
The other type of reverse convertible is known as a “knock-in.”
The structure is similar to that of the basic structure except that the price risk related to the linked security is set below that of the price at issuance—typically 70 to 80 percent of the initial “reference price.” Using the same example, at issuance the price of Intel is 25. That is the reference price. The knock-in level might be 20. Investors receive full principal back at maturity if the “knock-in level” is never breached. But if the knock-in level is ever breached, and at maturity Intel is trading below 25, the investor would receive Intel shares in repayment of principal. As under the basic structure, the number of shares received is based on the reference price.
Note that under either structure, investors have effectively sold a put to the issuer. Puts are options that have complex valuation formulas. They give the issuer the right, but not the obligation, to deliver Intel shares instead of repaying the principal. It is important for investors to understand that the more volatile the linked security, the greater the risk of the put being exercised (the more valuable the put is to the issuer). Also the longer the time frame, the more likely it is that the put will be exercised (the more valuable the put is to the issuer).
To review, under the knock-in structure, at maturity, there are two possible outcomes:
- Investors will receive the coupon plus the principal in the form of cash if the stock closes at or above the initial share price upon valuation date, regardless of whether the stock closed below the knock-in level during the holding period. They will also receive cash if the stock closes below the initial share price, but has never closed below the knock-in level.
- Investorswillreceive the coupon in cash plus the underlying shares if the stock closed below the knock-in level at any time during the holding period and does not trade back up above the initial share price on valuation date (four days prior to maturity). Investors then own the shares, though they are not required to hold them. The number of shares received will equal the initial investment/initial price of the underlying asset.
While issuers typically will offer to provide liquidity in the secondary market, there is no guarantee that the liquidity will be there. Also there is no guarantee that the secondary price will reflect changes in the underlying price. And the bid/offer spreads can be significant. Thus, investors should treat them as a buy and hold investment.
For tax purposes reverse convertibles are considered to have two components, a debt portion and a put option. At maturity, the option component is taxed as a short-term capital gain if the investor receives the cash settlement. In the case of physical delivery, the option component will reduce the tax basis of the reference shares delivered to their accounts. Investors should consult their own tax advisor prior to investing.
Some reverse convertibles grant the issuer the right, but not obligation, to call the bond prior to maturity. Of course, that right will only be exercised when it favors the issuer (when rates are low and the stock price of the linked security favors the investor).
Let’s take a look at two examples that demonstrate just how risky these securities are.
Turning Silk Into Sow’s Ears
In September 2007, investors bought reverse convertibles linked to Countrywide Financial Corp. with a yield of 22 percent. Unfortunately, Countrywide's share price sank more than 70 percent by the time the notes matured six months later in March 2008. The result was that investors lost more than half of their money, even after interest payments. The second case involves an even greater loss. In October 2007, Barclays issued a reverse convertible that was linked to Bear Stearns. The yield was 12.3 percent. Bear Stearns stock traded at well over $100 when the notes were issued. Unfortunately, the stock dropped by over 90 percent (2).
Who are the Issuers?
An important lesson for investors to learn is that before considering purchasing any security they should consider the transaction from the perspective of the issuer. The issuers of reverse convertibles are generally large financial institutions such as Morgan Stanley (NYSE:MS), Barclays PLC (NYSE:BCS) and ABN Amro Holding NV (ABN). These are highly sophisticated institutions. They don’t play Santa Claus. They are not in the business of issuing securities with higher costs than they would otherwise have to pay. Therefore, investors should ask themselves: Why do these firms issue these type notes with such high coupons? The answer should be obvious. It is because the issuers must believe that, despite the high coupons these notes carry, their cost of capital will be lower than if they issued other types of debt instruments. And that is exactly what the academic evidence from several studies on reverse convertibles found. Let’s look at the results of these studies.
Historical Evidence from Around the Globe
The July 2008 study, “Pricing (Multi-) Barrier Reverse Convertibles,” examined the Swiss market for reverse convertibles. The authors noted that these products were the “most popular and fastest growing segment of the Swiss market.” The study covered over 500 issues that traded between July 2006 and August 2007. They concluded that at issuance there were implicit premiums of between 2.5 and 3 percent, premiums that favored the issuers (3). In other words, investors were lowering the cost of capital for the issuers by about 3 percent—explaining why they are so popular with the issuers. The paper also cited a 2006 study on U.S. reverse convertibles that found significant overpricing. The authors of the study, “Gains from Structured Product Markets: The Case of Reverse-Exchangeable Securities,” concluded: “there is a significant pricing bias in favor of the issuer” (4).
A similar study, “Market Pricing of Exotic Structured Products: The Case of Multi-Asset Barrier Reverse Convertibles in Switzerland,” on 468 issues outstanding in April 2008, found an average over pricing of at least 3.4 percent. The authors concluded that “the overpricing is positively related to the coupon level, indicating that investors tend to overweight the sure coupon and underestimate the risk involved. This behavioral bias appears to be important in explaining the success of the product” (5).
The 2004 study, “An Empirical Analysis of Pricing Dutch Reverse Convertible Bonds,” also found significant overvaluations that the authors attributed to behavioral reasons— investors observe a high coupon rate, while they ignore the risk of a possible redemption of the bond below its par value. They noted that this was a very surprising result in light of the fact that until 2001 these issues were taxed in a very unfriendly manner (6). This paper cited prior studies on French and German reverse convertibles, both of which reached the same conclusions—investors overpay for this instruments. The study on French reverse convertibles found an overpricing of 12 percent (7). The study on German reverse convertibles found an overpricing of in excess of 3 percent (8).
What these studies demonstrate is that Wall Street is very good at designing product that separates capital from its owners.
It seems that investors all around the world are making the very same poor investment decisions. The errors are likely caused by a combination of behavioral mistakes and the lack of sophistication necessary to properly value these complex instruments. Investors underestimate the risks of equity investments, and in particular, the risks of individual stocks.
First, while the volatility of the stock market is high (the annual standard deviation of the market is about 18 percent), the volatility of individual stocks is much greater. The greater the volatility, the more valuable is the put sold by the investor to the issuer. Second, stock returns are not normally distributed—they exhibit both negative skewness (the values to the left of [less than] the mean are fewer but farther from the mean than are values to the right of the mean) and excess kurtosis (fat tails). The combination of high volatility, negative skewness and excess kurtosis creates the potential for very large losses—the risk of which investors persistently misprice.
The one thing we can be sure of is that financial institutions will continue exploiting investor mistakes. Charles Ellis provided this sage advice in his classic book Investment Policy: “Don’t invest in new or “interesting” investments. They are all too often designed to be sold to investors, not to be owned by investors.” Said another way, the complexity of financial investments is designed in favor of the issuer, not the buyer.
- Eleanor Laise, “Risky Strategy Lures Investors Seeking Yield,” Wall Street Journal, March 26, 2008, p. D1.
- Thomas Lindauer and Ralf Seiz, “Pricing (Multi-) Barrier Reverse Convertibles,” July 15, 2008.
- B.A. Benet, A. Giannetti, and S. Pissaris, “Gains from Structured Product Markets: The Case of Reverse-Exchangeable Securities (NYSE:RES),” Journal of Banking & Finance 30, 2006, p. 111-132.
- Martin Wallmeier and Martin Diethelm, “Market Pricing of Exotic Structured Products: The Case of Multi-Asset Barrier Reverse Convertibles in Switzerland,” April 2008.
- Marta Szymanowska, Jenke ter Horst, and Chris Veld,“An Empirical Analysis of Pricing Dutch Reverse Convertible Bonds,” March 2004.
- G.S. Roberts, V. Vijayraghavan, and S. Aintablian, “Stock Index-linked Debt and Shareholder Value: Evidence from the Paris Bourse, European Financial Management, 2002, p. 339-356.
- S. Wilkens, C. Erner, D. Lamprecht, and K. Röder, “The Pricing of Structured Products—An Empirical Investigation of the German market, Working Paper, University of Münster (Germany), 2003.
Disclaimer: Larry's opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management.