Banks sold more than $6 billion of reverse convertible notes last year, promising income investors returns of up to 64 percent in this historically low interest rate environment; however, reverse convertibles lost money, on average, according to a recent InvestmentNews articles entitled “Hot new asset class has ‘failed on all counts.'” In fact, reverse convertibles contain an often-hidden trap door called a put option, which can end up costing unsuspecting investors dearly.
According to Bloomberg, 1,481 reverse convertibles sold in the U.S. last year lost an average of 1 percent, compared with the Standard & Poor’s 500 stock index that returned 8 percent, and corporate bonds that gained 11.1 percent, during the same period.
“Here’s an asset class that’s basically failed on all counts,” Glenn Tongue, a money manager who oversees about $200 million with Whitney Tilson at T2 Partners LLC in New York, was quoted as saying. “I doubt these are being pitched as an opportunity to lose 1 percent,” he added.
True, and the loss can be worse than a 1 per cent.
Known by many names (UBS refers to them as Yield Optimization Notes) they are often sold to investors as safe income-producing investments. They are not. Reverse convertibles are, in reality, complex option combinations that put investors’ principal at risk. The high-yield, short-term note that investors think they are buying is linked to the performance of a “reference asset” such that, if the reference asset declines in value, the investor receives the depressed asset at maturity instead of a return of principal in cash. That is why FINRA has warned that these products are not suitable for investors with accounts not approved for options trading. These structured products are so opaque and complex that no ordinary investment advisor can properly evaluate them and disclose the risks to investors.
UBS Financial Services, Inc. is a big seller of structured products, including reverse convertibles, as are Citigroup, JPMorgan, Royal Bank of Canada, and Barclays Plc, according to the article.
Sales of structured products rose 46 percent last year to a record $49.4 billion in the U.S., according to Bloomberg. These securities were and are marketed to individual investors frustrated with record low rates on everything from certificates of deposit to money market funds. Banks issued $33.9 billion of structured products in 2009, according to StructuredRetailProducts.com, a database used by the industry.
Royal Bank of Scotland Group Plc sold $1.15 million of three-month notes linked to Eastman Kodak Co. that paid 24 percent annualized interest, according to the article. That is 24 times the average rate on one-year certificates of deposit.
But the 24% “interest” is, in part, an unexplained put premium paid by the bank in exchange for rights most investors don’t know they are giving the bank. Investors think they are buying a high-interest paying note and believe they will receive their principal back at maturity. But investors in reverse convertibles are essentially selling an option called a “put” to the issuing bank that gives the bank the right to put the reference asset back to the investor at maturity, in lieu of returning the investor’s principal, if the price of the reference asset does not stay within pre-determined limits.
For example, whether they knew it or not, buyers of the Kodak-linked reverse convertible “notes” stood to lose money if the shares of Kodak fell to below $3.54 from $5.06, which they did, according to the article. Kodak dropped to $3.50 on Aug. 31, and RBS put the depressed Kodak stock back to the investors instead of returning their principal. The investors suffered an 18 percent loss, even factoring in the high interest payments they received on the note, according to the article.
“This isn’t something that a retail investor calls up and asks for,” Marilyn Cohen, who oversees $250 million as chief executive officer of Envision Capital Management in Los Angeles, reportedly said. “Is it ever explained to them that you might end up with the stock and there’s a large probability that will happen?”
There is an additional risk component to reverse convertibles beyond the risk of receiving a reference asset that is worth less than the purchase price, and that is credit risk associated with the issuer. As the article points out, investors bear credit risk because the notes are unsecured debt of the issuer. If the issuer goes belly-up ? as Lehman Brothers did ? the investor is pretty much toast, too.
The Securities and Exchange Commission is investigating sellers of reverse convertibles. Last September, Kenneth Lench, head of the SEC’s structured products unit, reportedly said that the agency was examining whether brokers overcharged investors for the notes. Likewise, SEC Enforcement Director Robert Khuzami said the SEC has looked into sales of reverse convertibles.
State regulators are also fielding an “influx of concerns and complaints” from individual investors about structured products, including reverse convertibles, said Joseph Borg, director of the Alabama Securities Commission. Brokers who sell the investments sometimes don’t understand them, Borg said.
“The reason these are popular is they’re kind of an easy sale,” Charlie O’Flaherty, who used to oversee U.S. structured products and derivatives at Bank of Ireland, was quoted as saying. The products are marketed as a way to earn higher yields during times when stock prices are purported to be stable and interest rates are low, but buyers aren’t told how they have performed in the past, he said.
Why would brokers sell a complicated product that either they don’t understand, or that is not in their client’s best interest? Because they and their firms make out like bandits. The commissions sometimes exceed the securities’ maximum possible yield!
Banks charged fees that average 1.6 percent on a three-month reverse convertible, or about 6 percent a year, according to the article. By contrast, the average annual fee on stock mutual funds is 1 percent.
The three-month reverse convertibles sold by RBS and linked to Kodak paid brokers a 2.75 percent commission.
Investors who have purchased high-interest, short-term “notes” that are linked to a reference asset (e.g., a stock) should carefully review their brokerage statement covering the month in which the “note” is scheduled to mature, to see if they now own the reference asset. If they do, they may have lost money and may have a compelling claim to recover their losses.
“We continue to receive inquiries from investors who acquired these structured notes as a result of misrepresentations of them as a relatively safe note or bond investment,” said J. Boyd Page, a senior partner at Page Perry in Atlanta. “Our legal team continues to investigate and pursue arbitrations on behalf of investors who purchased these products,” he added. The brokers who sold the structured products are not targets of investor claims.
Page Perry is an Atlanta-based law firm with over 125 years collective experience representing institutional and individual investors in securities-related litigation and arbitration all over the country. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 40 occasions.