| Reverse Convertible Bond 101 |
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| 06/02/2005 | |
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Dr. Wolfgang Gerhardt, senior vice -president at the German private bank Sal. Oppenheim jr. & Cie. KGaA in Frankfurt answers this week's 101 on reverse convertible bonds. 1. What is a reverse convertible bond? High coupons are the hallmark of reverse convertible bonds. There is almost no other investment product which offers the opportunity of payouts of 7, 10 or even 12 per cent per annum. High coupons, however, correspond to a higher risk than a government bond: a reverse convertible bond refers to a certain share, especially shares of blue chip companies. At maturity the bond will be redeemed at 100 per cent of the nominal value or by delivery of a certain number of shares. In the case the share closes at the exercise day at or above a predetermined strike price, the issuer repays the nominal value, in the case of a share price below that level, the issuer delivers a certain number of shares. The coupon will be paid independently of the kind of redemption of the coupon. For the investor the maximum yield will be realised, if the bond is redeemed at 100 per cent. If shares are delivered the investor only suffers a loss in case the initial purchase price of the bond is higher than the market value of the shares plus any coupon payments. The choice of the issuer for the redemption could be interpreted as the willingness of the investor to buy a certain number of shares at a predetermined price. This fact explains the option structure: a reverse convertible bond is composed of the purchase of a traditional bond plus the sale of put options. The high coupon consists of the interest rate for the bond plus the option premium. The number of shares - or put options - multiplied by the strike price results in the nominal value of the bond. 2. How has the market developed? What kind of investor it is designed for? Reverse convertible bonds were offered to investors for the first time in the early 1990s. The market has developed in its present form in the late nineties. The leading issuers, which are the major banks in the field of derivative securities, constantly offer new reverse convertible bonds on the leading blue chip companies that are almost available with terms up to prevailing market conditions. This shows that the argument often discussed in the public that issuers try to sell own holdings of shares via reverse convertibles is misleading: the hedging is done by issuers on an ongoing basis like for any other derivative structure. The typical investor of a reverse convertible bond seeks for regular payouts due to the individual investment strategy. In Germany, for instance, the bulk of the buyers are retail investors, in other respects mainly investing in fixed income products, but also institutional investors, like insurance companies, pension funds, and foundations use that product to generate coupon income. It is important to mention that a comparable option structure could be found in other derivative structure: The so called "covered call writing", which means that an investor sells options on the holding of a certain number of shares, or the "discount certificates", which are often marketed as the "purchase of a share at a discount" offer exactly the same chance-risk profile as reverse convertible bonds. The only difference is that the option premium in the case of a discount certificate is distributed as a discount at the time of the purchase of the security. Especially in Germany, discount certificates have become a standard flow product in the world of derivative products outnumbering reverse convertible bonds by number of issues and turnover. Such certificates are bought by retail investors investing in shares. The investment decision between reverse convertible bonds and discount certificates is also based on different taxation features. 3. What make the product interesting? How attractive are reverse convertibles in the current market environment? The "unique selling proposition" of reverse convertible bonds is the fact that they allow for profits even if the equity markets remain stable or rise moderately. In this environment, reverse convertibles provide for a higher return than a direct investment in equity. Therefore, the turnover in these bonds depends on the forecast of the respective underlying: demand has been high in the case of a friendly market outlook, while it was low during the crises of the 2000 to 2003 market crash. Nowadays, the turnover has slowed down to a certain extent, because volatility and therefore option premiums have reached a historic low and therefore only allow for coupons in general below the psychological barrier of 10 per cent per annum. However, reverse convertibles are also considered as alternatives to foreign currency and high yield bonds. For many retail investors, information on a local share is much easier accessible due to the constant news flow on blue chip companies than the outlook for a foreign currency or the credit worthiness of an issuer with a low credit rating. Therefore, many investors have switched from these types of fixed income products to reverse convertible bonds thereby also forming a source of growth for this type of derivative securities. Interview by P.E. |
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Articles of the same Serie : 101 |
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