Introduction to Reverse Convertible Note (RCN)

If you are an income-hungry investor, stagnant stock markets or sluggish certificates of deposit (CD), currency markets, and bond yields may severely affect your cash flow.

When this happens, you may need to consider a short-term structured investment product: Reverse Convertible Notes (RCN). These securities provide predictable and stable income that can exceed traditional returns-even the returns of high-yield bonds. They also come with health risks. Read on to consider whether these notes can be added to your portfolio well.

Key points

  • Reverse Convertible Note (RCN) is a financial product that has the common characteristics of bonds and stocks by embedding put options on bonds.
  • RCNs may be attractive to some investors because they can provide higher yields than traditional corporate bonds in a relatively short period of time.
  • RCN is a complex asset with unique risk characteristics, so it is only suitable for investors who fully understand the risk/return profile of these securities.

RCN 101

A reverse convertible note is an investment that pays coupons at maturity. They are usually based on the performance of the underlying stock. Most periods of RCN range from three months to one year.

Large financial institutions usually issue notes. However, companies whose stocks are associated with RCN do not participate in these products at all.

RCN consists of two parts:

  1. Debt instrument
  2. A put option.

When you buy RCN, you are actually selling the issuer’s right to deliver the underlying asset to you at some point in the future.

How to determine expenditure

Before maturity, RCN pays the specified coupon rate, usually as a quarterly payment. This constant interest rate reflects the overall volatility of the underlying stock. The greater the potential volatility of stock performance, the greater the risk that investors will bear. The higher the risk, the greater the value you get from the put; this translates into a higher coupon rate.

When the RCN expires, you will get back 100% of your original investment or a predetermined number of underlying stocks. This number is determined by dividing your original investment amount by the initial price of the stock.

There are two structures used to determine whether you will receive the original investment amount or stocks:

  • Basic structure: At maturity, if the stock closes at or above the initial price, you will get 100% of the original investment amount. If the closing price of the stock is lower than the initial price, you will get a predetermined number of stocks. This means that the value of the stock you ultimately get will be lower than your original investment.
  • Knock-in structure: You will still receive 100% of the initial investment or shares of the underlying stock at maturity. However, with this structure, you will also get some downside protection.

example

For example, suppose your $13,000 RCN investment includes an 80% knock-in (or barrier) level, and the initial price of the underlying stock is $65. If during this period, the stock has never closed at $52 or lower, and the final price of the stock is higher than the strike price of $52, you will get back your original investment of $13,000.

If at any time during the investment period the closing price is US$52 or lower, and the final price is lower than the initial price of US$65 (assuming US$60), you will get a predetermined number of shares, that is, US$13,000 ÷ US$65 = 200 share. If you sold these shares at that time, it would be worth only $12,000.

If the closing price of the underlying stock is higher than the initial purchase price of $65, regardless of whether the $52 threshold is broken, you will eventually recover your initial investment.

RCN risks

Investing in RCN involves risks, and you may lose all or part of your principal at maturity. In addition, you do not participate in any increase in the value of the underlying asset above the initial price. Therefore, your total return is limited to the specified coupon rate.

However, before considering investing in RCN, you should further understand some other risks:

  • Credit risk: You rely on the issuing company’s ability to pay interest within the time limit and pay the principal when it is due.
  • Limited secondary market: You must be willing to accept the risk of holding RCN until maturity. However, investment companies that issue RCNs usually try to maintain the secondary market. However, this is not a guarantee; understand that if you sell, your income may be lower than the original cost.
  • Call terms: Some RCNs include a feature that can take your RCN from you when their yield is very high and the current interest rate is low.
  • Taxation: Since RCN is composed of two parts, debt instruments and put options, your returns may be subject to capital gains tax and ordinary income tax.

What types of investors are suitable for RCN?

RCN may be suitable for investors looking for a predictable, higher income stream than traditional fixed-income investments, and can bear the risk of losing part of the principal.

Investors should only buy RCN when they believe that the underlying stock will not fall below the knock-in level. Remember, the companies selling these investments are betting that the stock price will fall below the threshold set, or at least volatility is enough to make this possible.

Bottom line

Higher risks should have higher potential rewards, and this is also true for RCN. After all, where else can you invest as little as $1,000, get double-digit gains, and only bundle it in a relatively short period of time?

But don’t think that RCN can replace your CD, because there is no guarantee of principal. In addition, you should be satisfied with the underlying company of the RCN, because when your RCN expires, you may end up holding its stock. Therefore, please read the prospectus and prospectus carefully before investing. Finally, if you understand the ins and outs of the options, you should only invest in RCN.

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