FINRA to Investors in Reverse Convertibles: Caveat Emptor

Reverse convertibles--debt obligations tied to the performance of an unrelated security or basket of securities--attract investors looking for a higher current income stream than is currently available from other bonds or bank products in exchange for significantly greater risks.

But reverse convertibles, which banks and brokerage firms have been issuing and marketing in recent years, are not plain vanilla investment products. Indeed, their complexity has prompted FINRA to issue a new alert for investors, laying out in considerable detail the features and risks of reverse convertibles.

"They are complex investments that often involve terms, features and risks that can be difficult for individual investors and investment professionals alike to evaluate," FINRA says by way of introduction. "If you are considering a reverse convertible, be prepared to ask your broker or other financial professional lots of questions about the product's risks, features and fees and why it's right for you."

According to FINRA, a reverse convertible generally consists of a high-yield, short-term note of an issuer linked to the performance of an unrelated reference asset--this is often a single stock, but could be a basket of stocks, an index or some other asset. The purchaser receives a yield-enhanced bond, but does not own or get to participate in any appreciation of the underlying asset. Rather, in exchange for higher coupon payments during the note's life, the investor gives the issuer a put option on the underlying asset. The purchaser bets the value of the asset will remain stable or go up; the issuer bets the price will fall.

In addition, because the investor does not own the underlying security but rather the promise of the issuer to pay the income stream, the investor bears another type of risk: that the issuing bank or broker could itself default--the investor would then be a creditor of the issuer. According to FINRA: "A reverse convertible is an unsecured senior debt obligation of the issuer, meaning that the issuer is obligated to make the interest payments and final payments as promised. These promises, including any principal protection, are only as good as the financial health of the issuer that gives them and that issuer's ability to meet its obligations when they come due. While it is not a common occurrence that an issuer of a reverse convertible is unable to meet its obligations, it can happen."

Best result for the investor: a high coupon for the life of the investment and the return of full principal in cash. Worst result: if the underlying asset's value drops below the knock-in level, the issuer can pay back the principal in the form of the depreciated asset, which could mean loss of some or even all of the principal.

Michael S. Fischer (msf7@columbia.edu) is a New York-based financial writer and editor and a frequent contributor to Wealth Manager.