Several warnings have been issued over the years by sources such as the Wall Street Journal regarding the risk of investing in reverse convertibles. These risks have now become a reality for many investors who have allocations of the product in their portfolio.
The surge in demand for reverse convertibles began when Wall Street marketed a product with yields between 7 and 25% and very little downside risk. Sales began to soar while demand for fixed income products dropped due to the decline in conventional interest bearing product yields. Small investors purchased $8.5 billion in reverse convertible in 2007 alone. Some of the firms that have offered reverse convertibles include Morgan Stanley, Barclays, Wells Fargo, and ABM AMro Holding NV.
Reverse convertibles are alternative investments that are not suitable for all investors. Their complexity is hardly ever understood, and they are oftentimes misrepresented as fixed income products. Reverse convertibles are made of a note and a derivative. The note is a loan by the investor to the issuer that pays an income stream to the investor, while the derivative establishes the payment at maturity. The derivative can either be a put option, which would allow the issuer to sell the underlying derivative or security back to the investor, or it can be a call option, which would allow the issuer the right to buy the underlying security at a predetermined price. Also, investors may risk capital if they try to sell their reverse convertible prior to its maturity.
The Financial Industry Regulatory Authority (FINRA) has sent inquiries to brokerage firms regarding monitoring reverse convertible sales and marketing practices. Still, firms continue to hold out reverse convertibles as safe investments. Some firms even list reverse convertibles under CD alternatives. The NASD has suggested that only investors who are approved to trade options be allowed to purchase reverse convertible, but they pose a risk for even the most sophisticated investors.
Most investor are not capable of evaluating whether reverse convertibles are suitable investments. What investors should recognize though is that reverse convertibles put principal at risk if the price of the underlying security rises above or falls below a predetermined amount. The issuer will either sell or buy the security, which may cause investors to lose a significant amount of principal. However, investors are attracted to reverse convertibles because of their yields; reverse convertibles have average 13% in certain years. This comes as no surprise since yields on CDs and other conservative investments are near all-time lows, and fixed income investors need to generate income to pay bills and keep up with increasing costs. Still, investors must realize that reverse convertibles are not the solution. Rather than chase yields and risk losing hard earned savings, investors need to stick to what is suitable for them in order to avoid financial calamity.
Have you suffered a loss in a reverse convertible? If so, call Robert Pearce at the Law Offices of Robert Wayne Pearce, P.A. for a free consultation.
The most important of investors' rights is the right to be informed! This Investors' Rights blog post is by the Law Offices of Robert Wayne Pearce, P.A., located in Boca Raton, Florida. For over 30 years, Attorney Pearce has tried, arbitrated, and mediated hundreds of disputes involving complex securities, commodities and investment law issues. The lawyers at our law firm are devoted to protecting investors' rights throughout the United States and internationally! Please visit our website, www.secatty.com, post a comment, call (800) 732-2889, or email Mr. Pearce at email@example.com for answers to any of your questions about this blog post and/or any related matter.