The bottom line is that reverse convertibles come not only with the risks that fixed income products ordinarily carry—such as the risk of issuer default and inflation risk—but also with any additional risks of underlying asset.

The financial industry watchdog, FINRA (the Financial Industry Regulatory Authority), has recently issued warnings and alerts to investors concerning complex financial products. One of those products is the Reverse Convertible. In fact, after FINRA ordered RBC to pay more than $1.4 million in fines and restitution for the unsuitable sale of reverse convertibles, the agency reissued its original warning about these securities. But what is a reverse convertible and what’s all the fuss about?

What is a Reverse Convertible?

According to FINRA, “A reverse convertible is a structured product that generally consists of a high-yield, short-term note of the issuer that is linked to the performance of an unrelated reference asset—often a single stock but sometimes a basket of stocks, an index or some other asset. The product works like a package of financial instruments that typically has two components:

  • a debt instrument (usually a note and often called the "wrapper") that pays an above-market coupon (on a monthly or quarterly basis); and

  • a derivative, in the form of a put option, that gives the issuer the right to repay principal to the investor in the form of a set amount of the underlying asset, rather than cash, if the price of the underlying asset dips below a predetermined price (often referred to as the "knock-in" level).

Reverse convertible have become popular in recent years as investors have sought greater returns. These securities tend to offer much higher yields than traditional bonds. However, their combination of debt instrument and derivative means greater risk from multiple components.

Reverse convertibles, also known as “reverse exchangeable securities,” may not appear as such in your portfolio. Rather, they may have a brand name - the name of the company who sells or manages them. In that case, you may not even know you hold a reverse convertible.

What are the Risks and Downsides of Reverse Convertibles to Investors?

Financial Risk. Because reverse convertible involve both debt and derivatives, investors who hold them are subject to a variety of risks. There’s the risk of holding the debt instrument (including inflation and issuer default) PLUS the risks of the underlying assets, such as stocks and/or trading options. Often, unsophisticated investors will not be fully aware of these risks.

Fees. Reverse convertibles typically come with up-front embedded fees to investors. That’s money that you pay out but that will not go into the actual investment. Fees range from less than one percent to eight percent or more. Moreover, it is almost impossible for investors to figure out just how much the fee is because in order to do so, one would have to parce the actual securities into its constituent elements and determine the discrete fees, then add them up.

Are Reverse Convertibles Suitable for You?

For most retail investors, the answer is probably no. Because of the financial risk and generally high fees, structured products like reverse convertibles are not suitable for ordinary investors, particularly those with low tolerances for risk. However, financial advisors will often recommend these products as alternatives to traditional bond products, hoping to deliver higher yields. While they may offer higher yields, what brokers are often reluctant to talk about is the higher risk and fees that come with reverse convertibles. Be very careful you fully understand how these products work and what risks you run investing in them before adding them to your portfolio.

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