The question of what are reverse convertible bonds can be answered in various ways. Negatively delimited: Equity bonds are neither real bonds nor equity investments. At the same time, however, they contain the characteristics of equities and bonds.
The English name: Reverse convertible bonds.
What are reverse convertible bonds? Certificates, not bonds
In terms of their classification, reverse convertibles are structured products. And that makes them certificates. In addition, there are various variants of reverse convertibles.
What reverse convertibles really are is best understood by looking at their function.
A reverse convertible has a certain term and an interest coupon – just like a bond.
The difference: it refers to an underlying asset. This can be a share or a share index.
When a reverse convertible is issued, the offeror determines the strike price. The strike price is equal to the price of the underlying security.
What the investor receives in what form at the end of the term depends entirely on the performance of the underlying asset.
In any case, he receives one thing: the agreed interest. This is the fixed income component. The second component consists of the possibilities: Money or shares.
If the shares have finally risen above the initial value, i.e. the strike price, gibt´s interest plus the invested money. If the shares are listed below it, you get the interest and instead of money the shares themselves.
This play with one fixed and two alternative yield variables marks stock loans. The distribution of interest always remains the same, as previously determined – no matter how high the price deviation may be.
What are reverse convertible bonds? An example
Example: A reverse convertible refers to 10 shares. Interest rate: 10%. Term: 1 year. The shares are listed at 100 %. Accordingly, the base price per share is € 100 (usually just below the price).
If you buy the 10 shares at a nominal amount of €1,000, there are 2 options at the end of the term.
1) The price is 100 € above the strike price. Then you get the nominal amount of 1.000 € back and additional 100 € interest.
2) The course is 90 € below the basic price. Then you get the 10 shares and also 100 € interest.
You can either hold the shares and wait for better times or sell them. If you sell them for 900 €, you have not made a loss because of the interest payment.
In this respect, the interest payment is a kind of safety buffer. But only as long as the closing price is not below 10% in the minus.
Interest rates, terms and base prices can of course vary depending on the product and provider. Since interest rates make a reverse convertible attractive in the first place, they are usually quite high. Otherwise nobody would be interested in them.
What are reverse convertible bonds? Good at least in sideways phases
For investors, reverse convertibles therefore pay off predominantly in sideways phases. If the price remains more or less unchanged, the investor can at least enjoy the generous coupon. 8% or 10% and more are not bad.
However, if the stock market were to rise steeply, it would be better to invest directly in shares if prices were significantly higher than the strike price.
And equity bonds are not safer either. Although the loss is limited by the interest payment with falling prices. But if an offerer goes broke, the investor goes empty-handed.
Among other things, this shows what reverse convertibles are: Strictly speaking, they are certificates. The name is avoided because certificates and security no longer go together in the public consciousness.
Equity bonds work in a similar way to discount certificates. Only that the return does not come from the discount.
The term bond should therefore not be misleading. Moreover, when an investor receives the shares, he automatically becomes a stock investor. There can then be no question of a bond.
In general, it can be said that reverse convertible bonds are certificates with a fixed coupon whose performance is linked to the underlying asset.
Equity bonds – The slightly different bond
Reverse convertible bonds, also known as cash or share bonds, belong to the group of investment products and are linked to the performance of an underlying share, the underlying instrument. If the bond refers to an index, the security is referred to as an index bond. The products are capped, which excludes participation in price increases above a certain price threshold, the strike price, of the underlying stock.
Probably the most important feature of reverse convertibles is the issuer’s option at maturity to decide whether to repay the investor the principal amount evidenced by the bond or to deliver a specified number of shares. During the term, reverse convertible bonds have an interest rate that is usually higher than the current market interest rate at the time of issue, which is mainly due to the issuer’s option mentioned above.
How do reverse convertibles work in detail?
Reverse convertible bonds are normally listed not in euros, but as a percentage of the nominal amount. First, the investor acquires the reverse convertible at a certain nominal value, for example at a nominal value of 10,000 euros. An annual interest payment is usually made during the term of the bond. A special feature of the reverse convertible bond is that it is linked to the performance of the underlying share. The underlying value is important for the reverse convertible because the issuer, i.e. the issuer of the bond, can decide at maturity whether to deliver these shares to the holder of the bond instead of repaying the capital. The issuer will exercise this right if it has a financial advantage. An example illustrates when this is the case.
A possible scenario for the reverse convertible could be that the customer initially invests 10,000 euros as the nominal amount. The underlying security mentioned in the terms and conditions of the bond is, for example, the Deutsche Telekom share. The terms also stipulate that the issuer has the option of delivering 1,000 of these shares to the bondholder on maturity instead of the capital repayment. However, the issuer will only exercise this option if the price of the Deutsche Telekom shares is below EUR 10 at the time the bond matures. In this case, the value of the shares would be lower than the nominal value of the reverse convertible, which, as mentioned above, is EUR 10,000. The strike price of EUR 10 is exactly the threshold that determines whether the issuer will repay the nominal value or deliver the shares. If the price of the Telekom shares is above ten euros, the issuer would decide to repay the nominal value, as this is cheaper for him than delivering the shares. As a general rule, the greater the difference between the strike price and the price on the issue date, the greater the chance that the investor will avoid redeeming the reverse convertible with shares. In any case, the repayment modalities should be read in the terms of issue before buying a reverse convertible.