Over at the Baseline Scenario, James Kwak has a good example of the sort of thing the new Financial Products Safety Commission should be regulating: reverse convertible bonds (read his article here). With these you get a relatively high coupon, say 10%. The overall return though is tied to the performance of an underlying stock. The bank or broker, though, does not actually buy the underlying stock.

For example, you give a bank $100 for a year, and get a $10 coupon payment. The principal at the end of the year is tied, though, to how well XYZ stock does. If the stock closes above say $80, you get your $100 back. If it ends up above that level you get the value of the stock. Analytically, this is the same as buying the stock and writing a covered call on it; or to writing a naked put and holding onto your cash.

However, it is likely to be marketed to relatively unsophisticated investors, not the type who know how to properly price options. You have to show some degree of financial sophistication to open up an options account, and this is simply a way for banks to trick conservative investors into playing a risky game.

Relative to just buying the stock, there are three potential outcomes:

  • The stock closes below $80: In this case, the reverse convert is somewhat better. You get the stock, but at least you also got the $10 coupon. Since you didn’t get the dividend on the stock, you make out better (relative to just buying the stock) if it is zero dividend stock like Bed Bath and Beyond (BBY) than if it is a high-dividend stock like AT&T (T). However, you still lose money on the deal.
  • The stock ends up between $80 and $110: In which case you do better to the extent the 10% rate on the reverse convert exceeds the dividend. Assuming a non-dividend payer, $110 would be your break even level.  
  • The stock does well and ends up over $110: Then you have simply lost all your upside.

There is a place for writing covered calls, however — usually it is when a long-time holder of the stock is thinking the stock is near its price target, at which point he would sell anyway, but does not want to sell right away since it would trigger big capital gains taxes.

Buying and immediately writing covered calls on a stock is generally not a good thing to do, since it virtually assures that you will cut your winners and let your losers run. If the stock collapses to $50, you still have a big loss, and that $10 coupon is not that much comfort.

In any case, if you want to play that game, why pay the fees to the bank or broker that is pushing the reverse convert and just do it yourself? You would actually have some understanding then of what you are doing.

This is a good example of a financial innovation what simply serves to increase fees to the banks, and make investments more complex and harder to understand for unsophisticated investors. It does nothing to help allocate capital more efficiently or more productively. They are one more financial innovation that the economy could easily do with out.

My advice is to stay away from these things, and from any broker or banker that is trying to push them on you. The only exception is if you think you can spot mispriced options better than the bank or broker can, but then again, if that is the case, why bother with this instead of just playing the options market on your own?

Read the full analyst report on “BBY”
Read the full analyst report on “T”
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