14 August 2009

Reverse Convertibles - do you really understand the maths?

An article in today's Wall Street Journal (16 June 2009) points out the dangers of this form of bond. The investor gets a seemingly very attractive coupon but most investors are not aware that the high coupon payment is the result of an embedded put option that the investor sells.
Most retail investors - and we would include so-called 'High Networth Individuals' - are unlikely to understand the detailed workings of options, let alone the possible pitfalls of selling a naked option.
Investors are easily persuaded to go for these 'free lunches' and take the high current income which is dangled in front of them by eager salesmen of financial 'advisors'. But the danger that is in most cases only mentioned in the small print and glossed over during the sale process is the fact that the investor may end up with the underlying shares of the issuing entity if they have declined by a specified amount by maturity.
These shares are likely to be worth considerably less than the stated principal of the convertible bond and their value will on average be 20 - 30% below nominal value of the bond depending on the terms of the bond issue.