Now let's take a look at reverse convertibles, another type of structured product that combines an enhanced coupon with equity exposure, a reverse convertible offers investors a higher than usual coupon, but with a trade off.
If the underlying equity falls below a certain level at maturity, the investor may receive back shares instead of cash.
This is different from a standard fixed income product where the principle is always repaid in full.
The term reverse convertible reflects the key difference from traditional convertible bonds.
Instead of the investor having the right to convert a bond into stock in a reverse convertible, the issuer holds the option to deliver stock instead of cash at maturity.
If the underlying asset falls below the conversion level, and that's how the structure generates a higher coupon, the investor effectively sells a put option on the underlying stock.
The premium received from selling this put is added to the normal deposit interest boosting the total coupon.
Let's walk through an example of a one year reverse convertible linked to Apple stock.
Suppose the investor puts $100,000 into the note.
The note pays a fixed 10% coupon, meaning they receive $10,000 in interest regardless of how apple's share price performs.
However, at maturity, the investor's outcome depends on the stock price relative to the conversion level, which in this case is set at 100% of the initial stock price.
If apple remains at or above this level, the investors simply receives their full $100,000 investment back in cash, along with the $10,000 coupon, meaning they walk away with a total payout of $110,000.
If apple declines below the conversion level, the investor no longer receives cash, but instead gets Apple shares.
If the Apple stock price ends at 90% of the initial price, the number of shares the investor receives is calculated by dividing their initial $100,000 investment by the conversion level, meaning they receive the same number of shares regardless of the price drop at 90% of the original price.
The value of these shares would be $90,000, meaning the investor has taken a 10% capital loss.
However, because they still receive the $10,000 coupon, their total payout is $100,000 fully Offsetting the capital loss and resulting in a break even outcome.
If Apple falls further to end up at 80% of its initial level, the investors still receives the same fixed number of shares, but now these shares are worth only $80,000 at maturity.
Although they still receive the $10,000 coupon, their total payout is now only $90,000, meaning they would've suffered a net loss of $10,000 on their original investment.
The further apple declines, the greater the capital loss, as the investor remains fully exposed to downside risk.
Although this example assumes physical delivery of Apple shares, many reverse convertibles are now cash settled, meaning the investor receives a cash equivalent instead of shares.
This is especially common for reverse convertibles linked to equity baskets, commodities, or indices where physical settlement is impractical or even impossible.
The main appeal of a reverse convertible is its higher yield.
However, this comes with downside risk.
If the stock falls, the investor may end up holding shares instead of receiving cash, meaning they could experience capital losses.
Reverse convertibles can be a useful tool for income seeking investors who are willing to take on some equity risk in exchange for enhanced yield, particularly if they are comfortable potentially owning the underlying stock at a lower price.
