Reverse Convertible Bonds

In the previous few articles, we studied about convertible bonds and how these bonds are different as compared to regular bonds. Investors who start investing in convertible bonds often come across another category called reverse convertible bonds. These bonds have distinct features such as high yield and shorter maturity which makes them attractive to certain types of investors. However, these bonds are also considered to be quite risky which is why investors are often advised to understand the product before they actually make an investment.

The details of reverse convertible bonds as well as some of the features associated with these bonds have been listed in the article.

What are Reverse Convertible Bonds?

Reverse convertible bonds are financial products that combine the features of both, debt as well as equity. In most cases, this means that they are debt instruments that have embedded derivatives.

Let’s understand this with the help of an example.

Let’s consider a bond with a face value of $100 and which pays an 8% yield. Let’s also assume that this bond has a 2-year maturity. The value of the bond will be linked to a stock or a basket of stocks. Now, during the 2 years, the investor will continue to receive the 8% yield regardless of the share price. However, the redemption of the original principal is linked to the underlying share price.

If the share price at the time of redemption is equal to or greater than the share price when the bond was issued, then the entire face value of $100 will be returned. In this case, the investor would have earned 8% yields for 2 years in addition to their original investment.

However, if the share price at redemption is lower than the initial value, then the payment is received in kind. This means that instead of receiving their principal amount back in cash form, the investor will have possession of the underlying asset (shares).

If the share price is 16% lower than the original value, then the investor will break even since he/she has also received two coupon payments. However, if it goes any further down, the investor would suffer a loss. It is important to note that profit and loss are being considered based on nominal values. The time value of money calculation is not being included to ensure simplicity.

Downside Protection in Reverse Convertible Bonds?

There are many investors who are afraid of investing in reverse convertible bonds because there is no downside protection. For such investors, a different variant of reverse convertible bonds is also available. This variant has been named as downside protect reverse convertible bond to signify the function which it performs. These bonds work by reducing the threshold at which the bonds will be converted to shares. Let’s once again consider the same example as above.

The difference in these bonds is that the conversion to shares may happen at a lower rate, let’s say 70% of the initial value. This means that the investor gets a 30% buffer which lowers their risk. This means that if the value of the underlying stock is 85% of the initial value, then too, the investor will receive back their entire initial investment. This will be the case till 70% of the initial value.

If the current market price at redemption is 69% of the initial price, then the investor will have to accept shares in lieu of their principal amount. However, it must be noted that the additional protection provided is not free of cost.

Bonds that have downside protection will provide a lower annual coupon rate as opposed to regular reverse convertible bonds. In simple terms, this means that the difference between the regular coupon and the lower coupon is the premium paid in order to obtain this protection.

In most cases, the reduction in coupon rate will be commensurate with the downside protection provided. This means that if 30% downside protection is provided, then the coupon rate will also be 30% lower. Bonds which provide downside protection are also important since they serve a different class of investors. These investors do not want to take too much risk and are happy with a lower return.

Conclusion

The bottom line is that reverse convertible bonds are actually a combination of debt as well as a put option. The annual coupon rate is actually a premium that is being paid by the bond issuer which will allow them to settle their debt with shares of lower value if the share value falls below a certain pre-determined price. The option entitles the issuer to sell their lower-priced shares in exchange for a higher-priced bond.

The coupon rate which the investor receives is actually a combination of annual interest rate as well as option premium. This is why the nominal coupon rates appear to be higher. However, if the coupon rates are adjusted for risk, they generally provide the same returns as regular bonds within the same risk category.

The bottom line is that reverse convertible bonds are a very specific type of debt instrument which are considered to be very useful for certain types of investors. These investors are different than usual bond investors since they have a higher risk tolerance and are looking for products with short-term maturity.

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