Advantages and Disadvantages of Reverse Convertible Bonds

Reverse convertible bonds have a significant market size. They are sold by many companies and investment banks around the world. This is the reason that they may appear to be a compelling option for many investors.

However, reverse convertible bonds have certain distinct advantages and disadvantages. The advantages and disadvantages have been mentioned in this article. Needless to say that this list only comprises of the commonly listed pros and cons and should not be considered to be exhaustive.

Advantages of Reverse Convertible Bonds

The main advantages which attract investors to reverse convertible bonds have been listed below:

  • Higher Yield: Firstly, it is important to note that reverse convertible bonds provide a significantly higher yield as compared to regular bonds. This also means that they are riskier than regular bonds. However, there are many investors who have a risk appetite and hence are willing to buy these bonds in order to increase their cash flow. As already discussed in previous articles, this higher yield is generally because of the premium derived by selling naked put options on the issuer’s stock.

  • Higher Profits in Sideways Moving Markets: The demand for reverse convertible bonds generally increases when investors believe that the market is going to move sideways. This means that after a short period of time when the bond matures, the prices are expected to be in a similar range as they are today. In such cases, investors make a much higher return by investing in reverse convertible bonds.

  • Better Than Buying and Holding Stock: A lot of investors use reverse convertible bonds as a surrogate way to buy shares. This means that they want to buy the shares of the underlying company, to begin with. However, if they directly buy shares and hold them, they will receive a much smaller dividend as compared to the coupon rate which is paid to such bonds.

    For such investors, it makes financial sense to buy reverse convertible bonds. This is because they are already prepared for the worst outcome which would be to end up holding shares that are declining in value. Hence, reverse convertible bonds are ways to enhance short-term returns for investors who plan to take an extremely long-term position.

  • Lower Lock-Ins: The maturity of the reverse convertible bonds is very low are compared to regular bonds. Most reverse convertible bonds are sold with maturities between three months and two years. Hence they are preferred by investors who want liquidity and hence are averse to making investments that are extremely long-term in nature.

Disadvantages of Reverse Convertible Bonds

Reverse convertible bonds are often criticized by long-term bond investors. This is because they feel that the disadvantages of such bonds are much more as compared to the advantages provided by these bonds. Some of the disadvantages have been listed below:

  • Lower Liquidity: Firstly, it needs to be understood that there is a very limited secondary market for reverse convertible bonds. This is because these bonds are not widely held by a lot of investors.

    Hence, the transaction volume is not enough to provide on-demand liquidity to investors. From an investor's point of view, this means that they should be comfortable holding the bonds until maturity. If they try to liquidate their bonds mid-term, it is quite unlikely that they will be able to do so without taking a significant hit on the valuation. The lower liquidity can be a deal-breaker for many investors.

  • Higher Risk: Also, many investors are wary about the higher returns which are provided by these bonds. This is because they are wary of companies who would want to pay a higher coupon payment to investors when they can get away with a lower payment.

    According to such investors, the issuing company has insider information about the state of its operations. If people with insider information are betting on the fact that their stock prices might go lower in the future, then investing in such companies is inherently risky. This is because the stock price also has an impact on the credit quality and therefore the bond prices.

  • Credit Risk: Lastly, it is a known fact, that companies resort to structured notes such as reverse convertible bonds only when they cannot raise money using traditional securities. Usually, they cannot raise money because they are over-leveraged or have bad credit. Hence, in such cases, the investor who buys reverse convertible bonds is also exposing himself to significant credit risk.

    It is also quite possible, that the company selling the bonds may not be in any position to make coupon payments or even repay the principal amount back. In such cases, investors might end up losing the entire amount.

    It is possible to mitigate this risk by purchasing a credit derivative which will make the investor whole if a loss ever occurs. However, the premium which is paid to buy such a derivative often eats into the higher yields being provided by the bonds making this strategy unviable, to begin with.

Experts in financial markets and critics generally do not view reverse convertible bonds in a favourable light. This is because according to them, the risks far outweigh any possible gains which can be attributed to higher yield. However, some classes of investors still believe that the pros outweigh the cons and hence continue investing in these bonds.

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