Basic reverse convertibles are notes whose repayment of principal is linked to the reference asset’s lowest value during the note’s term. If the reference asset’s value falls below a pre-specified level during the term of the note, investors receive substantially less than the note’s face value. Basic reverse convertibles tend to pay higher coupon rates than traditional notes because they expose investors to much more risk than traditional notes.
A common basic reverse convertible has the same payoffs as an unsecured note issued by the brokerage firm and a contingent at-the-money short put option on the reference asset. If the reference asset’s value falls below a threshold or “trigger” price at any point during the term of the note, the contingent put option is activated and the reverse convertible note will pay the lesser of the face value of the note and the market value of the number of shares of the reference asset which could have been purchased on the note’s pricing date with the note’s face value. If the reference asset’s value never drops below the trigger price, the reverse convertible note will pay investors the face value of the note at maturity.
Some brokerage firms issued “enhanced” reverse convertibles that exposed investors to both the downside risk and the appreciation potential of the reference asset if the trigger was breached. Such “enhanced” reverse convertibles include ELKS®, issued by Morgan Stanley, and some Yield Optimization Notes with Contingent Protection issued by UBS.
These “enhanced” reverse convertibles appear to be more valuable than the other basic reverse convertibles because the payoff at maturity isn’t capped if the note converts into the reference asset. However, this advantage is illusory. It is unlikely that once the underlying security’s value drops below the trigger level it will rebound back above the initial level during the remaining term of the note.
Basic reverse convertibles have been sold by many different brokerage firms including JP Morgan, Barclays, Citigroup, Morgan Stanley, Wachovia, Lehman Brothers, Royal Bank of Canada, and ABN Amro. Although many firms have branded their reverse convertibles, most are similar in structure. Table 1 lists a few of the names under which basic reverse convertibles have been sold by various brokerage firms.