Reverse Convertible Notes Offer Tempting Yields

Yields of up to 30 percent offered by reverse convertible notes are making the complex products increasingly tempting to income-starved investors – but the products have also caught the attention of state and federal regulators concerned with the risks posed by the structured notes.

A recent investigation by the Financial Industry Regulatory Authority resulted in a $2 million fine against Wells Fargo Investments LLC for selling reverse convertible securities through one broker to elderly clients unsuited to risky investments. As part of the settlement, FINRA required Wells Fargo to provide restitution to clients for “serious failings that harmed investors.”

FINRA also filed a complaint against a former Wells Fargo registered representative who recommended and sold unsuitable reverse convertible securities to 21 clients, mostly senior citizens older than 80 with limited investment experience and low risk tolerance, said the authority in a statement announcing the enforcement action.

Regulators may fear that reverse convertible notes are too complex and risky for the average investor, but retail sales of the structured products grew by 46 percent to a record $49.4 billion in 2011, according to Bloomberg News. Sales were poised to set a new record in 2011, reaching $30 billion by mid-year, according to the Structured Products Association.

The appeal of the products lies in the high yields they offer. Also known as “revertible notes” and “reverse exchangeable securities,” reverse convertible notes are debt obligations typically tied to the performance of a single stock or bundle of stocks.

“Although often described as debt instruments, they are far more complex that a traditional bond and involve elements of options trading,” said FINRA. A reverse convertible exposes investors to several layers of risk – those associated with bonds and other fixed income products added to the risks of owning stocks. The combination leaves investors exposed to the risk of default by the issuing company, the possibility that income will fail to keep pace with inflation and the risk that could lose money on their original investment. Difficult to decipher fees are also embedded in the products.

A reverse convertible packages two financial instruments, a note that pays an above-market coupon and a derivative in the form or a put option. The option gives the reverse convertible issuer the right to repay an investor’s principal in the form of stock shares should the price of the stock dips below a preset value.

“You are betting that the value of the underlying asset will remain stable or go up, while the issuer is betting that the price will fall,” said FINRA. In the best-case scenario, investors will receive a 100 percent return of the original investment, plus receipts from the high coupon. In the worst case, if the value of the underlying stock falls below the preset level, the issuer can pay back investors in the form of the depreciated assets, said FINRA, “which means you can wind up losing some, or even all, of your principal.”

“A reverse convertible might make sense for an investor who wants a higher stream of current income than is currently available from other bonds or bank products – and who is willing to give up any appreciation in the value of the underlying asset,” said FINRA. “But, in exchange for these higher yields, investors in these products take on significantly greater risks.”

Millionaires are twice as likely as non-Millionaires to take on the risks posed by a reverse convertible, according to the fourth quarter study by Millionaire Corner on the attitudes and behaviors of wealth investors. Only 2 percent of those with a net worth of $100,000 to $1 million own reverse convertibles for an average of balance of $66,000. That share doubles to 4 percent of investors with a net worth of $1 million to $5 million, who have an average of $177,000 invested in the products. Twice as many investors – 8 percent – with a net worth of $5 million to $25 million own a structured product, such as a reverse convertible, for an average balance of $628,000.