The reverse convertible bond sparks a lively debate

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A debate has emerged online (based on this article in The Wall Street Journal) about the financial the instrument known as a reverse convertible bond. A regular convertible bond pays the owner interest, and gives him an option to swap his debt for a pre-determined number of shares in the company. A reverse convertible also pays the owner interest, but means he may be given stock instead of principal if shares in the company fall by a certain amount.

Felix Salmon of Reuters started things off by calling the product a "scam" that should be outlawed. But on Seeking Alpha, Vincent Fernando disagreed -- essentially saying that personal responsibility needs to be allowed to take its course, and individual investors are best suited to make their investment decisions based on the various choices available to them. And, as Fernando rightly notes, a reverse convertible position can't lose anything beyond what one would lose simply owning the stock.

The truth of the particular cases highlighted where reverse convertibles caused loses probably somewhere in between. The risk of loss was likely under-emphasized by those doing the selling, but the buyers were likely aware there was risk involved -- otherwise, why would they earn an outsize yield? Regardless, this is an excellent example of why investors must carefully consider selling options against their portfolio.

A reverse convertible basically involves selling a put option; the extra yield that seems to be offered is in reality a premium for accepting downside risk. Like all things in the markets, the attractiveness of the strategy is highly relative to its recent performance -- in a flat or rising market, reverse convertibles do fine; in a bear market, the opposite is true. As the Journal article notes, issuance of the notes in 2008 amounted to $7 billion, but so far in 2009 a mere $1 billion has been transacted.

The strategy is similar to writing covered calls, where investors own a stock and give up potential future upside in exchange for an upfront premium. ETFs that use the method, like the Powershares S&P 500 BuyWrite (PBP), have outperformed the S&P by about 10 percent since the market peaked in October 2007. But the longer-term market trend over that time is down, and those market conditions favor collecting premiums compared to simple stock ownership. The BuyWrite ETF has underperformed by approximately 10percent since the start of March, as the market rose.

The lesson? Investors need to be aware that there is no free lunch in the markets; earning extra yield through writing options comes at a cost over a full market cycle. And in this case in particular, although a reverse convertible is marketed as a "bond," it is like a high-yield bond at best and like owning a stock at the worst.

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