Words like “new and different” or “new and improved” might pique your interest when it comes to computers or cleaning products. But if your broker offers you a newfangled investment product, especially one that seems really complicated, watch out. The overriding purpose of Wall Street’s inventiveness is first, last, and always to generate fees and commissions and to create an environment in which investment banks win in the end, even if investors lose.
If a new or revamped product is really complicated, your chances of getting burned go way up. Complexity and opacity ensure that you – and most likely your broker – won’t understand how things could go terribly wrong until they’ve gone terribly wrong. We’re not exaggerating when we say that innovative and complex investment products offered by Wall Street are almost always really good for broker-dealers and really bad for investors.
The Reverse Convertible Note
One case in point is a recent investment innovation widely referred to as a “reverse convertible note.” Reverse convertibles are debt obligations of the issuer that are tied to the performance of an unrelated security or basket of securities. Although often described as bonds, they’re far more complex than a traditional bond and involve elements of options trading.
One reverse convertible that recently made the rounds and now is making news is a so-called note tied to the performance of Apple stock. Various broker-dealers issued these things under a variety of names, but to be clear, Apple Inc. had no connection whatever to these investments. The use of Apple’s share performance as a benchmark was just an element in a scheme by investment banks to parlay the public’s excitement over Apple into a huge payday for the banks.
As is usually the case with tricky products, stockbrokers either didn’t fully understand the investments themselves or misrepresented them to customers. The broker typically would describe one of these things as a bond or say it was “like a bond,” a very safe short-term debt instrument but with fabulous monthly interest payments. The product generally would mature one year from issuance. If Apple stock went up in price during that year or even if it dropped somewhat, a note holder would get those great interest payments each month and would have his or her entire principal investment returned at maturity. In the unlikely event Apple stock sharply declined during the term of the note (by perhaps 15% to 20% or so) and hit a preset threshold called the “knock-in price,” the brokerage firm would keep the note holder’s principal at maturity but would instead give the note holder Apple stock.
If you’re one of the thousands of investors who bought these Apple-linked products, the recent big downturn in the price of Apple has or is about to deliver a very unpleasant surprise. Why? Because when your note matures, you’ll own Apple shares that are likely to be worth far less than the amount you invested in the note. In fact, you may lose 25% or more on these “safe” and allegedly bond-like investments.
For example, suppose you bought a reverse convertible note for $700, roughly the same value as one share of Apple at that time. As various analysts and journalists have noted, you would be in the same position as someone who sells a cash-secured “naked” put option. (If you’re interested, read our section on Options.) You would essentially have assumed the risk that if the price of Apple falls far enough, your original investment of $700 would be treated as the purchase price for Apple stock, even though the shares you receive might now be trading at well below that price. In other words, if Apple shares are only worth $500 when your note matures, you’ll have paid $700 for a share worth $500, and you’ll have lost nearly 30%.
Negatives of Reverse Convertibles
These reverse convertibles frequently were sold to people who had no business buying them – i.e., people seeking safe, income-producing investments. Why would they buy them? Brokers happily talked about the great interest payments but typically failed to mention the not-so-great features of these investments, including:
- Reverse convertibles expose you not only to risks traditionally associated with bonds and other fixed income products—such as the risk of issuer default and inflation risk — but also to the additional risks of the stock to which the reverse convertible is tied, in this case Apple.
- When investing in a reverse convertible, you effectively buy a note from the issuer and sell a put option to the issuer simultaneously, so if you don’t have the risk tolerance for selling put options generally, you might not want to invest in a security that contains the equivalent of one.
- The broker-dealer was charging you an up-front embedded fee (2% or much more) for assembling and packaging the reverse convertible’s individual components, but if you wanted to know the true size of this embedded fee, you’d find it virtually impossible to calculate.
- Because secondary trading for the reverse convertible would be limited or non-existent, the investment would be highly illiquid.
- A reverse convertible is an unsecured senior debt obligation of the issuer, meaning that the promise of interest payments and return of principal is only as good as that issuer’s ability to meet its obligations when due. Defaults are rare but do happen, a prime example being the $8 billion of Lehman Brothers 100% Principal Protected Notes outstanding at the time of that firm’s collapse.
Of course, as is usually the case with complex structured products, this may have been a rotten deal for you, the customer, but it was a terrific deal for your brokerage firm. How so? To begin with, the firm would get that whopping fee for selling the note. Next, the firm would get the benefit of owning Apple stock purchased with your money. The firm would get to keep the dividends paid (now running at around 2.3%). And, if the Apple stock went up in value, the firm would keep that increase. If, on the other hand, there is a significant drop in the Apple stock price and it breached the knock-in point, it would be you who took the risk, not the firm. The firm would simply keep your invested principal while it unloaded the devalued shares on you. These benefits to the firm more than make up for the interest it would pay you for the use of your money for the year. And to add insult to injury, if you decided to sell the devalued Apple stock, you’d likely do it through the firm and would have to pay the firm a commission for the privilege.
The Financial Industry Regulatory Authority warned broker-dealers back in 2010 that reverse convertibles aren’t suitable for most individuals, and that brokers should only offer these investments to a very select group of investors and only in conjunction with full and fair disclosure. If you get burned by one of these Apple-linked structured products or by reverse convertibles linked to other companies and benchmarks, don’t be a passive victim. Call us. Contact Hugh Berkson or Tony Hartman at (216) 781-5515 or toll free at (800) 789-2389, or reach us through the consultation form on the right of this page. We’ve helped hundreds of aggrieved investors. Talk to us about how we can help you.