Reverse Convertible Notes and Similar Non-Conventional Investments are Unsuitable for Many Investors
Sales of poorly understood, non-conventional investments tend to increase in low-yield environments like the present. Reverse convertible notes are an example of this dangerous trend, says Jeff Benjamin in his recent InvestmentNews article, “Reverse convertible notes warrant sales scrutiny.”
Also known as "revertible notes" or "reverse exchangeable securities"—and sold under a variety of proprietary names that may or may not use the term "structured" to describe the product—reverse convertibles are debt obligations of the issuer that are tied to the performance of an unrelated security or basket of securities. While often described as debt instruments, they are far more complex than a traditional bond and involve elements of options trading. Reverse convertibles expose investors not only to risks associated with bonds but also to the additional risks of the unrelated assets, which are often stocks.
They work like this: In exchange for higher interest payments, the investor gives the issuer the right to repay principal 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. The investor (whether he knows it or not) is betting that the value of the underlying asset will remain stable or go up, while the issuer is betting that the price will fall. If the value of the underlying asset stays even or rises, the investor receives a high coupon for the life of the investment and the return of his full principal in cash. But, if the value of the underlying asset drops below its “knock-in” level, the issuer can pay back the investor with the depreciated asset—which means the investor loses some or all of his principal (offset only partially by the monthly or quarterly interest payments).
According to the article, a higher coupon yield signals a greater likelihood of the linked asset dropping below its knock-in level. This is because the coupon payment, currently averaging around 12%, is based on the linked asset’s most recent option price volatility.
It’s no different than rolling the dice. Why would brokers put their clients in a casino game? Perhaps because sales of such securities generate commissions or 2% or more – a sure thing for the broker.
The Financial Industry Regulatory Authority (FINRA) recently issued its first enforcement action involving the sale of reverse convertibles, in which it reminded the brokerage industry of its suitability obligations. FINRA fined H&R Block Financial Advisors Inc. $200,000 for inadequate supervision of reverse convertible sales and also ordered the firm to pay $75,000 in restitution to a retired couple who had their portfolio 40% allocated to reverse convertibles, according to the article.
The representative was reportedly fined $10,000, ordered to disgorge $2,023 in commissions and suspended from working with any FINRA-associated firm for 15 days.
FINRA also published an alert to investors that reverse convertibles “often involve terms, features and risk that can be difficult for individual investors and investment professionals alike to evaluate.”
FINRA also said that firms selling structured products that have a prominent option component should consider restricting sales to clients who are eligible to trade options. Firms should only “consider” not selling these speculative products to conservative investors? What a polite, friendly regulator.
Reverse convertible notes are speculative, high-risk investments that are totally inappropriate and unsuitable for most income-oriented investors. Conservative investors who have suffered significant losses in such products may have compelling claims to recover those losses.
Page Perry, LLC is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. For further information, please contact us.
