May 19, 2008: Reverse Convertibles, An Interesting Speculation

A reverse convertible investment offers investors an opportunity to receive a high coupon and a predictable income stream. At maturity, the investor will receive either their original investment amount or a predetermined number of shares of the underlying stock whose value will be lower than the investor's original investment amount.

Speculators who might consider reverse convertible investments in their portfolio includes those seeking a higher interest rate than can be found on conventional fixed-income investments, individuals willing to accept the risk of owning the underlying equity, investors knowledgeable and comfortable investing in options and those seeking to diversify and spice up their overall portfolio return.

Reverse convertibles, sometimes called reverse exchangeables, are a short term investment linked to an underlying stock. At maturity, the investor will receive either 100% of their original investment amount or stock, in addition to the stated coupon payment. If shares of stock are given to the investor, their value will almost surely be less than the original investment amount. It is important to note that the investor's earning potential is limited to the security's stated coupon.

Reverse convertibles are generally issued with maturities of six months to two years. They are typically issued with above market rate coupons that range from 8-15%per annum. The coupon is paid regardless of whether the investor receives stock or cash at maturity. Most reverse convertibles can be purchased for a minimum of $1,000.00 and in increments of $1,000.00 thereafter. Reverse convertibles usually maintain a rather thin secondary market. Because reverse convertibles consist of two components, a debt instrument and an option, they are subject to special tax treatment (consult your accountant).Many reverse convertibles feature what is called "knock-in" protection that limits loss. This downside protection is a laudable feature. Almost all reverse convertibles are originated from large worldwide bank holding companies in Western Europe.

Here are a few examples of reverse convertibles:

Underlying Stock: Apple (AAPL)
Term: 6 months
Annual Interest Rate: 14% paid monthly
Downside Price Protection:25%
Closing Date: 5/27/08

Underlying Stock: General Electric (GE)
Term: 6 months
Annual Interest Rate: 8.25% paid monthly
Downside Price Protection: 15%
Closing Date: 5/27/2008

Underlying Stock: Arch Coal (ACI)
Term: 6 months
Annual Interest Rate: 13% paid monthly
Downside Price Protection: 35%
Closing Date: 5/27/2008

Underlying Stock: Ford Motor (F)
Term: 6 months
Annual Interest Rate: 14.25% paid monthly
Downside Price Protection: 30%
Closing Date: 5/27/2008

Underlying Stock: First Solar (FSLR)
Term: 6 months
Annual Interest Rate: 20% paid monthly
Downside Price Protection: 50%
Closing Date 5/7/2008

These are a few examples of the scores of reverse convertibles available.

I am a firm believer that one should not invest in a product that is not fully understood.This article scratched the surface. There are facets of reverse convertibles that you should study carefully and comprehend prior to considering an investment in this instrument.

One good source of information is presented on the website of the Federally Insured Savings Network (www.fisn.com/CDalternatives.htm). Don't confuse the web site title with the speculative nature of this investment.

Exploring eclectic investments such as reverse convertibles is an interesting exercise, and may lead the experienced investor to a rewarding source of income.