Stupid investment of the week: Reverse convertible securities

Midge and Walter are 70-something retirees in Arizona, concerned about the losses they have taken not only in the stock market, but in their bond mutual funds, and feeling the need to goose their income in order to make sure it lasts out their days.

So Walter followed up on a newspaper ad he saw about high-yield investments backed by companies, and wound up getting a sales pitch from a Tucson area financial adviser about "reverse convertible securities," which promise a "predictable, steady stream of income," where the investor at maturity receives "either 100 percent of their original investment amount or a predetermined number of shares of the underlying stock, in addition to the stated coupon payment."

Unable to fully grasp that clear-as-mud language, Walter's now stuck on one feature of these investments — the double-digit yield he can get on his money.

He figures that the worst-case scenario is that he captures the big yield, and is left with some shares in a stock like Freeport-McMoRan, Monsanto or Arch Coal.

"I've owned convertibles before with no problems," he said in an e-mail, "and this looks like a way to get more yield without taking too much risk."

Midge, meanwhile, figures that the whole thing sounds too good to be true.

She's not completely right about that, because there are cases where these complex products might work, but there's little denying right now that stretching for yield through reverse convertible securities is the Stupid Investment of the Week.

Stupid Investment of the Week highlights the traits and concerns that make a security less than ideal for the average investor, in the hope that spotlighting one dangerous situation will make trouble easier to uncover and avoid elsewhere. This column is not meant to be an automatic sell signal, as dumping a worrisome investment sometimes exacerbates the problem.

That's distinctly true for reverse convertibles, where the lack of a secondary market makes them virtually impossible to unload at a fair price before maturity.

There is, however, a growing market for reverse convertibles with the public, as sales have increased dramatically over the last few years and most industry watchers expect sales to top $10 billion for 2008.

That's not surprising because reverse convertibles are exactly the kind of thing Wall Street sharpies come up with when nothing else is selling and they need to keep the cash pipeline flowing in order to qualify for their fat annual bonus. What's particularly egregious about reverse convertibles is that they are being sold as a reasonably safe alternative investment when, in fact, virtually all of the downside risk falls on the buyer.

Here's how it works:

Reverse convertibles are unsecured — and sometimes unregistered — short-term notes, typically with a duration lasting six months to two years, linked to the price of an underlying stock. One big sign of trouble is that the stocks involved typically are not for the ones issuing the securities; this isn't some newfangled way for companies — like the ones that caught Walter's eye — to raise capital, it's just a different way for financial underwriters to get you to play roulette with your investment dollars.

Effectively, you're combining a debt instrument and a put option, selling the issuer the right to give you the underlying stock at some point in the future.

During the holding period, the security has a high coupon rate; double-digits are the current norm, peaking in the neighborhood of 25 percent. (Many reverse convertibles have a minimum initial investment of $1,000, part of their appeal to small investors.)

When the security matures, the investor gets the big interest payment plus either the return of their original investment or a predetermined number of shares in the underlying stock. There are two different structures for determining how the payoff works, but here's the plain English on the possible outcomes:

If the price of the underlying stock goes up, you get back the interest payment and your cash.

If the stock declines in price — or trades for a single day below a specified "knock-in point" — you get the promised interest payment, plus the shares. Since the shares have lost value since you entered the deal, you lose a corresponding amount of principal, even if you turn right around and dump the shares for cash.

Here's an example: You buy a $10,000 one-year reverse convertible linked to XYZ stock, which is trading at $10, and has a 15 percent coupon rate. The deal has a "knock-in price" of $7 per share, giving you more downside protection than in a basic reverse-convertible deal.

If XYZ is up at the end of the year, you get back your 10 grand, plus $1,500 in interest. That's the same outcome you get if the stock falls, but never goes below the knock-in price for as much as a single day while you hold the security.

But if XYZ is worth less than $10 per share at maturity and the stock closed at least one day below $7, you've been "knocked in" to trouble.

You'll get the $1,500 coupon payment in cash, plus 1,000 shares of XYZ (your $10,000 divided by the "reference price" at time of purchase). So, if XYZ is trading at $8.50 per share at maturity and once crossed the $7 line, you finish the year with the same $10,000 you started with; if the stock ends the period at $6 per share, you're getting back cash and securities totaling $7,500.

In short, you are getting the stock's downside risk, without capturing any upside potential; the stock could triple, and you're no richer, but if it craters, you get hammered. Ask investors in some widely issued reverse convertibles backed by Countrywide Financial stock how good that felt.

The sellers of these products say they are right for people looking for higher rates of return than are available on conventional notes, who don't mind the risk of the underlying stock, who are comfortable with options and are looking for ways to diversify their portfolio.

The problem is that a whole lot of people fit loosely under that description, and most of those prospective buyers — like Midge and Walter — are focused on the wrong features of these investments.

"People get mesmerized by the high yield," said Larry Swedroe of Buckingham Asset Management in St. Louis. "That is what attracts them to the shiny red apple that the witch is holding. They don't realize that when they are looking at something like a reverse convertible that there's poison in there too. ... The yield sounds great, but in the end you can't make that much, but you can lose a huge amount."

Chuck Jaffe is senior columnist for MarketWatch. He does not own or hold short positions in any securities covered by Stupid Investment of the Week. If you have a suggestion for Chuck Jaffe's Stupid Investment of the Week or a comment about this week's column, you can reach him at jaffe@marketwatch.com or Box 70, Cohasset, MA 02025-0070.