Reverse Convertibles and 'EIPs' – Here’s The Point

by: Marc Gerstein

For the uninitiated, a reverse convertible (or structured product) is a short-term debt instrument that usually pays an above-market rate of interest but contains a provision that could allow the borrower to repay principal, not in cash, but in stock. The shares usually aren’t the shares of the company that borrows the money. Citibank, for example, might issue a reverse convertible that could, under certain condition, be repaid in shares of, say, Apple. The equity repayment provision is usually activated by a decline in the price of the specified stock (20%or so, even if the decline is only temporary, with the details specified in the debt documentation).

In one of several reverse-convertibles articles featured recently on the Seeking Alpha home page, James Kwak asks: “What the hell is the point of this product?”

I have an answer.

Besides the usual one (the desire of the issuer to make money, akin to the desire every business has for every commercial transaction), the grander societal goal is to provide recipients with a higher yield than they could get from normal debt instruments of bank accounts.

Stop! Calm down . . . I can already feel the reactions bubbling up; deluded retail investors seeking something for nothing, sleazy brokers, advisers and institutions salivating at a chance to jump in. OK. OK. We know the drill. We’ve seen it time and again. Now let’s get past the tabloid stuff and get to the serious issues.

Low interest rates are usually described as a blessing. I certainly don’t need to explain why to a Seeking Alpha audience.

Less widely discussed is the dark side of low interest rates (and there is one, since no coin is one sided); the difficulties experienced by people who need to live off the income generated by their savings. Low single-digit interest rates are a boon to borrowers, but they’re hell on those who supply savings.

For many years we’ve been able to mute the problem through a bull market. One can look the other way at the notion of living off principal when the value of the principal is soaring higher than anyone’s most optimistic expectations. But now, and for who-knows-how-long, we’re back in an era when living off principal can be tantamount to financial suicide.

So the idea of stretching income beyond normal market levels isn’t just a gimmick for financial avarice. For many, it’s a necessity.

Unfortunately, it’s not easy and all of the present-day solutions leave much to be desired.

One way to stretch income is the classic; allocate funds to riskier investments. Junk bonds are one answer. REITs might suffice. Low-quality utility stocks are another approach. The downside, here, is obvious. The bad scenarios really happen and, it seems, more often and to a greater extent than can be addressed by diversification.

Annuities, particularly equity indexed annuities, are another solution. However the terms of these breathtakingly complex contracts are often far more onerous than many realize when they get in. (If you like Jackson Pollack paintings or surrealist literature you really should try to get your hands on one of these documents!)

The other solution involves structured products, or as we’re labeling them now, reverse convertibles. These, actually, are not that difficult to understand (Kwak’s description was clear and concise) and the risks may not be so terrible. That’s what Morningstar believes, and they are not at all shy when it comes to screaming about sucker bets and portfolio-killing products.

I’m certainly not shy when it comes to disagreeing with Morningstar, but I think they’re spot on when they described reverse convertibles as cash-secured put options and use puts as a framework for describing the risks and potential returns. I also agree with them that education regarding these products has been badly lacking.

Back to the issue of income stretching . . .

Enhanced Income Products – In Theory

I see annuities and reverse convertibles as two aspects of what I’m going to label EIPs, Enhanced Income Products. I don’t believe this label is out there. If not, I’m happy to invent it right here and now.

The idea behind an EIP is to find a way to give an investor an above-market rate of income. For a financial institution to accomplish that, and remain at least solvent and preferably profitable, it will need to find a way to make more money on those funds that it can through standard means. Today’s generation of EIPs is accomplishing that through stock market participation (direct and or via derivatives).

Essentially, ABC National Bank or ABC Insurance Co. tells John Doe:

You want more income than you can get through a CD. We want more float. Here’s how we can work together. We’re going to take the money you give us and play the market. We’re going to enhance your income by sharing some of our extra profit with you. Some of that bonus will be contractually guaranteed. Other amunts will vary with how well we do. We also understand you want to limit your risk, so we’re gong to contractually offer you some sort of downside protection. We’ll manage our own downside by hedging, by our ability to earn more upside than we share with you, etc.

This is good for us because we think at the end of the day, the fees and market returns we earn will more than offset the above-market interest and downside protection we offer you. Meanwhile, you get a heck of a lot more income than you otherwise could. We understand it’s not perfect because you are taking some downside exposure, but hopefully, you’ll find the risk to be reasonable in light of the extra income you can earn if things go right.

If you look at annuities and reverse convertibles, you’ll see that one way or another, this generally is what lies at the core. And it can become a good thing for the many who need to stretch their income.

Today’s Reality

Unfortunately for today’s generation of individual investors, EIPs are presently in the stone age, or perhaps, the Robber Barron era. The reality looks very grim.

The best we can say for any of what’s out there is that the products have some potential if used correctly but that the state of education (not just for investors but also for their advisors) ranges from non-existent to dismal. That hurts not only because the wrong people are winding up in the wrong products (an outcome that, in and of itself, is likely to turn very sour very fast) but it also contributes to the poor quality of many of the products currently being offered.

Try to envision what goes on as EIPs are created. Consider it a mental contest between seller and buyer.

On one side, we have the sellers, major financial institutions who employ armies of professionals with advanced degrees in finance, economics and actuarial science, backed by additional armies of high powered accountants and lawyers. All these people are well compensated by the seller and, naturally, dedicated to protecting the seller’s best interests.

On the other side, we have the buyers, individuals who may or may not know the difference between PE and PEG and even if they are expert in basic stocks and bonds probably have little or no grasp of hedging and probability-based price modeling. Their advisors, if they have any at all, may just be glorified sales people with little expertise in anything except brochures containing pretty pictures and, of course, fee schedules. As to those who have talented advisors (let’s not get cynical, there are many of these), the latter often aren’t experts in the heavy-duty quant topics.

Who do you think is going to win in a contest like that? How well do you think the buyers interests will be protected?

Looking Ahead

Long term, I believe the EIP will become a vital part of the financial landscape because it’s needed.

Getting from here to there, however, will be a challenge. Somehow or other, the imbalance described above is going to have to be corrected. That’s the only way we’re going to have rational sellers interacting with rational buyers in a way that will allow the basic forces of supply and demand to combine to create a reasonable set of products; annuities, reverse convertibles, and any other variations that may be developed.

I don’t know right now how this comes about. Maybe a new financial consumer protection authority takes a direct hand in regulating these products (hopefully, such an agency would work with its own team of financial, etc. professionals to step in on behalf of the individual investor). Maybe it will involve a new type of certification for advisers and sales people who are required to get some serious education in this area and who are put under bona fide fiduciary duties as to what sort of products can be selected in light of a particular client’s circumstances. Maybe we need to hear from a lot more gurus and authors who expound on the pros and cons of particular offerings just the way they now do regarding stocks, mutual funds and ETFs. Maybe we need all of the above. Undoubtedly, there are things I haven’t thought of.

But there’s one thing we definitely do not need: the sort of rants we’ve seen recently in connection with both annuities and reverse convertibles. Hysteria and outrage help nobody. Thoughtful analysis and discussion helps everyone.

Disclosures: None