Reverse convertible bonds
Reverse convertible bonds have been experiencing a renaissance since the year 2009. According to the "Handelsblatt" more and more capital is invested in reverse convertibles. While there have been about 8,500 reverse convertible bonds in December 2008, based on DAX values as base value, with 28,600 the number of offered products has more than tripled.
A reverse convertible bond (also equity-linked bond ) is a structured financial product. Its most important feature is the issuer's option to either repay 100% of the normal amount of the bond to the investor at the end of the term or to deliver a certain number of (predefined) shares During the term the investor receives one or more interest payments (coupon payments).
Examples:
The customer (C) buys 10 units of shares configured as a certificate via the bond issuer (I) on 01.01.2011. Underlying asset is the A-share, which stands at a price of 100 EUR at the time of purchase. C acquires the certificates with a nominal value of 1,000 EUR at a price of the stock loan of 100% and an annual coupon of 10%. The term is one year. At the end of the term the issuer has the right to deliver shares to the customer at a predetermined ratio. In this case the customer shall get for the bond 10 A-shares at a nominal value of 1,000 EUR. He is to receive interest in any case.
Case 1: The A-share stands at 100 EUR on 31.12.2011.
| price A-share | price certificate | piece | norminal value | book value | Coupon 10% | output / income |
|---|---|---|---|---|---|---|---|
at acquisition | 100 € | 100% | 10 | 1.000 € | 1.000 € | 1.000 € | |
at maturity | 100 € | 100% | 10 | 1.000 € | 1.000 € | 100 € | 1.100 € |
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| 100 € |
C pays 1,000 EUR upon acquisition. Upon maturity I has the right to deliver 10 shares or to repay 1,000 EUR to C. C receives interest at a rate of 100 EUR regardless. Before taxes C makes a profit amounting to 100 EUR. The expenses of I are limited to the predetermined interest payment.
Case 2: The A-share stands at 200 EUR on 31.12.2011
price A-share | price certificate | piece | nominal value | book value | Coupon 10% | output / income | |
|---|---|---|---|---|---|---|---|
at acquisition | 100 € | 100% | 10 | 1000 € | 1000 € | 1000 € | |
at maturity | 200 € | 100% | 10 | 1000 € | 2000 € | 100 € | 1100 € |
100 € |
Upon acquisition C pays EUR 1,000. Since it would be more expensive for I to procure 10 shares at book value of 200 EUR, I pays EUR 1,000 back to C. Thus K does not participate in any increase in price of A shares. He is in the same position as if the share price at the end of the term was still listed at 100 EUR. I carries virtually no risk. His effort is limited to the interest payments in the amount of 100 EUR.
Case 3: The A-share stands at 500 EUR on 31.12.2011
price A-share | price certificate | piece | normal value | book value | Coupon 10% | output / income | |
|---|---|---|---|---|---|---|---|
at acquisition | 100 € | 100% | 10 | 1.000 € | 1.000 € | 1.000 € | |
at maturity | 50 € | 100% | 10 | 1.000 € | 500 € | 100 € | 600 € |
-400 € |
Upon maturity C will be supplied with 10 shares worth 50 EUR each in accordance with the option of I. The value of the shares amounts to 500 EUR. If C then sold his shares, he would make a loss of 500 EUR. This loss is mitigated by the interest payment of 100 EUR, which he will receive upon maturity.
I carries no risk. On the contrary, he benefits: he has to procure shares with a value of 500 EUR and can retain the 1,000 EUR paid by C. His expense is limited only to the interest payment in the amount of 100 EUR.
Case 4: I is insolvent.
Should I become insolvent, neither the repayment nor the interest payment is still ensured for C. One speaks of the so-called issuer risk. C suffers a total loss in terms of capital employed.
Conclusion:
The reverse convertible poses significant risks for the customer. This should be pointed out in a consultation. So even at acquisition it is not sure whether the customer will get back the capital invested. In any case - with the exception of the issuer's insolvency - the investor should receive the coupon payment.
At (repeated) failure of these payments there is reason for a review of the factual and legal situation.
Lately, however, requests from clients who have found that interest payments are not made to the announced date or repeatedly fail or that the repayment is in danger due to an issuer who has gotten into difficulties, are piling up.
"Investors should obtain legal advice from a competent lawyer, especially if you did not understand the principle of the reverse convertible at the time of consultation or if you were wrongly advised regarding the outlined goals to the investment adviser," said attorney Matthias Berger.