Beware Reverse Convertibles

EDITOR'S NOTE: This article was originally published in the July 2010 issue of Kiplinger's Retirement Report. To subscribe, click here.

With interest rates in the pits, double-digit yields on reverse convertibles are mighty tempting. But retirees looking for safe fixed-income investments may be wise to steer clear: You'll get your interest but risk losing part of your original investment.

Reverse convertibles are short-term bonds that are tied to the performance of a stock. If the price of the underlying stock drops below a certain level during the term of the note, the investor gets the depressed-priced shares at maturity instead of a full return of principal.

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In a volatile market, that’s a risky bet. "Corporate bond yields may be lower, but at least you get your investment back. With reverse convertibles, you may not get your principal," says John Gannon, senior vice-president of the Financial Industry Regulatory Authority.

That's what many retirees who bought reverse convertibles learned the hard way during the 2007-09 bear market. But, with interest rates still low, big banks expect that reverse convertibles will continue to attract yield-hungry investors. Barclays, ABN Amro and JPMorgan Chase have already released millions of dollars in new issues this year.

To get an idea of how reverse convertibles work, consider a three-month note issued on April 30 by JPMorgan Chase and linked to AK Steel Holding Co. Assume an investor sank $1,000 in this issue, which pays interest of 3.46%, equivalent to $13.85 a year.

AK Steel's share price was $17.43 when the security was issued. The note sets a "knock-in price" of $13.94, which was 80% of the initial stock price.

The investor in a reverse convertible always gets an interest payment. But getting the full principal back depends on what happens with the stock price. As long as the stock price never falls below the knock-in price during the note's term, the full principal will be returned to the investor when the note matures. (Investors never benefit from the stock's upside.) If the price at maturity is under the knock-in price, the investor receives either cash or the shares of stock.

The investor's principal is at risk, though, if the stock falls below the knock-in price even for a single day. If that happens, to receive the full principal, the price at the note's maturity must be at or higher than the initial price.

The principal of investors in the note on AK Steel is in jeopardy: On May 20, the share price of AK Steel dropped to $13.40. On June 14, the share price was $13.96. Those investors must wait until July 30 to see if they will get back their full principal. If the final price remains above the knock-in price at maturity but is less than the initial price, investors will receive cash or the depressed shares, according to bank documents.

Brokers Convince Investors That Notes Are Safe

Geoffrey Evers, a lawyer in Sacramento, Cal., has filed a number of FINRA arbitration claims against brokers who sold his clients reverse convertibles. He says his typical client is an elderly investor who holds most of his or her savings in certificates of deposit in large banks.

The financial institution persuades the investor to move the money to the broker side and invest in reverse convertibles, Evers says. "These investors are promised that they're investing in a safe bond with higher returns," he says.

In February, FINRA issued an investor alert on reverse convertibles, warning that these securities "can be difficult for individual investors and investment professionals alike to evaluate." Download the alert at www.finra.org.

If your broker recommends reverse convertibles, read the prospectus carefully. The JPMorgan Chase documents filed with the Securities and Exchange Commission did contain warnings that "the notes do not guarantee the return of your principal."

Also, understand that the higher the interest rate, the more volatile the stock and the more likely the stock price will drop below the knock-in price. If you don't want to end up with shares of the underlying stock, don't invest.