Every time there is a significant downturn in the market, Wall Street’s “rocket scientists” conjure up complex new products that purport to be conservative and pay hefty returns but end up slamming investors. Add reverse convertibles to the list of failed products that meets this description.
Reverse convertibles are short-term bonds that pay high yields and are coupled to well known stocks. The bonds generally have terms of three months to one year and promise to repay the investor their principal plus unusually high interest rates (generally between 6% and 13%) unless the price of the underlying stock drops below a certain level (called the “knock in” level) which is usually 20% or so below its market price at the time the reverse convertible is sold. In that event, the investor does not get back any of his principal or interest but instead gets stock worth far less than the amount of his investment and suffers significant losses.
In 2008, many conservative investors were decimated by this product. According to the investors, they were told that there was no risk in reverse convertibles and that they were appropriate for conservative investors. Contrary to the representations made by Wall Street firms, reverse convertibles are an extremely risky structured finance product. Investors get slammed and experience huge losses if the price of the stock moves in the wrong direction, which is exactly what happened last year.
Notwithstanding the damage that reverse convertibles inflicted on many investors last year, some Wall Street firms continue to hawk these products to conservative investors. Investors are urged to be very careful if a broker recommends this product to them.
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