Tutorial: Reverse convertibles

What are Reverse Convertibles?

Reverse Convertibles are debentures with a very attractive interest rate. Given that the bond is linked to a share (underlying), coupons are substantially above market rates. In return for the high coupon, the investor also bears the risk from the share: at the end of maturity, the redemption of the share bond is based on the price of the underlying instrument. If at the end of maturity the share price is above the initial value, the coupon and the nominal value are redeemed. If the share price at the end of maturity is below the initial value, the initially agreed on number of shares per nominal value are transferred (usually physical delivery) on top of the coupon.

In addition to Reverse Convertibles with one underlying instrument, there are also Reverse Convertibles with more shares as underlying instruments. These multi-cash or multi-share bonds tend to pay a higher coupon. Their redemption is based on the share with the worst performance at the end of maturity. A fixed coupon is paid out here as well, regardless of the way of redemption.

How do Reverse Convertibles work?

Reverse Convertibles come with an initially set fixed coupon at the end of maturity that pays substantially higher interest rates than the market. If at the end of maturity the market price of the underlying is above the strike price fixed at the beginning of the term, the share bond is redeemed at its nominal value plus coupon. If the share price is below the initial value, the investor receives a physical delivery of the share plus the payment of the coupon. The number of shares to be delivered per nominal value is set at the beginning of the term.

In the case of the multi-cash or multi-share bond which has more than one shares as underlying, redemption is based on the share with the worst performance. If at the end of maturity the price of this share is above its initial value, the bond is redeemed at its nominal value plus its coupon.

If at the end of maturity the price of the share with the worst performance is below its initial value, the investor receives the share by means of physical delivery, plus the payment of the coupon. The number of shares to be delivered per nominal value is also set at the beginning of the term.

Your benefits

Investors who do not expect any strong movements in a share can receive a high, fixed coupon when investing in a Reverse Convertible. In return, the upward potential is limited to the value of the coupon. This form of investment is highly interesting in an environment of attractively valued equity markets.

Your advantages

You get a high, fixed coupon that is above the market interest rate
Reverse Convertibles tend to have short maturities.
The fixed coupon offers you a risk buffer.

Details you should be aware of

In the case of redemption by physical delivery of shares, you may incur losses.
Between issue date and maturity, price fluctuations are possible, which means that the sale of the Reverse Convertible prior to maturity may result in a loss.
The potential return is limited to the coupon.

How do Reverse Convertible react to…

… rising imarkets?
If the price of the underlying share rises, the price of the bond rises as well because the redemption of the nominal value is becoming more likely.

… stable markets?
In stable markets, the investor benefits from the fixed coupon and the redemption at nominal value at the end of maturity. The stable price has very little influence on the value of the bond, but the value of the bond rises as the remaining period to maturity shortens.

… falling markets?
If the price of the underlying share falls, the price of the bond falls as well because the redemption of the nominal value by means of physical delivery of the share is becoming more likely. The fixed coupon is paid out in any case.

Payoff-Chart

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