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Monday, March 21, 2011

How reverse convertible securities work

The Financial Management Regulatory Authority (FINRA) describes reverse convertibles as short-term, high-yield financial instruments comprise of debt instruments and put options. This means that the reverse convertible bond is only converted if the underlying stocks drop below a certain value. In essence these financial instruments are corporate hedges against loss in market capitalization or a decline in stock value.

Reverse convertible securities are thought to work in favor of the borrower by allowing them an increased measure of financial risk management. This is because this type of debt instrument has the option to be reversed by the issuer of the security.  In other words, reverse convertible securities are financial instruments, usually short-term bonds called notes, that allow lenders to change the actual financial instrument after it has been sold. As the following brief video discusses however, there are drawbacks to financial instruments such as reverse covertible notes such as high fees that have led to arbitration issues in the past.

To illustrate how reverse convertible securities work, XYZ Corporation contracts ABC Underwriting corporation to issue $100,000 in reverse convertible bonds to anyone willing to buy the bonds. If after selling the bonds, XYZ Corporation wished to change the type of debt which implies a change to the terms of debt, then they have the freedom to do so because the financial instrument is a reverse convertible security.

Reverse convertible securities can be used for a number of financial purposes because they are diverse financial instruments linked to credit and debt management. For example, by issuing reverse convertible bonds, a company can increase its debt to credit ratio if the money obtained is not used. Since these types of loans may be more favored by other lenders, the company may then obtain lower cost financing elsewhere and then convert the security to equity.

The Seattle Times called reverse convertible securities a stupid investment in late 2008 because the net affect of owning them was little different to owning stocks affected by the financial crisis even though the initial terms had high interest rates hedged by 'good' stocks. For investors, it is probably a good idea to consider how and why these securities are issued in the first place. In other words, companies may issue reverse convertible securities to manage their own financial risk at the expense of the investor. When financial instruments become complex, in some cases, that may serve as warning to the investor to be aware of increased money losing conditions i.e. financial deception via complexity.

A financial principle that may be ignored with reverse convertible securities is the economic cycle i.e. purchasing reverse convertible securities may be a bad idea during periods of economic contraction, but what if the reverse is true? In such case the investment may at least be less risky. That is to say, if the underlying stock is fundamentally strong, and forecasted to have extended increased profit margins for three or more fiscal quarters, the risk of not obtaining one's complete investment principal back is reduced.

Of course, during economic upcycles, a new risk emerges with reverse convertible securities, namely opportunity cost. The opportunity cost is that bonds are generally not the choice investment during these times because other investments may provide higher yields. In light of this, reverse convertible securities may be considered for higher yielding bond diversification only during periods of economic growth.