Finding Income in Today’s World: Reverse Convertibles

With the national debt exceeding $16 trillion, the U.S. government has been engaged in a practice called financial repression. The term financial repression was introduced in 1973 and is a technique which helps a country dig out of deep debt. I'll dispense with its definition and focus on its practical aspects.

First, the problem in the U.S. is rather obvious. If interest rates rise very far, the cost of servicing the public debt would pose a problem. Because of this, Washington has purposely engaged in this practice to maintain artificially low interest rates with the hope that the economy will soon begin to grow at a more normal level. To be precise, the economy has been growing, but this recovery ranks as the second weakest in the post-WWII era. Moreover, with no sign of significant improvement, it's safe to assume that low interest rates will be here for a while. Obviously, low rates help the government but hurt anyone relying on income from their investments. With this as a backdrop, I'd like to discuss a very good income-generating alternative called a reverse convertible. Here's how they work. 

A reverse convertible is a bond issued by a bank with a period to maturity, an annual interest rate (paid monthly), and a buffer and is sold in $1,000 increments.  Moreover, the performance of these instruments is based on the price of an underlying stock. To better understand it, let's assume the following: 

Issuer: Best Bank

Underlying Company: XYZ

Strike Price: $10.00 per share

Buffer: 75%

Term: 12 Months

Interest Rate: 12%

Using the above example, a person would invest a dollar amount, for instance, $10,000. Each month, the investor will receive an interest payment based on the annual rate. At the end of the term, the investor would receive bacl either the original principal or shares of the stock. Again, no matter how the stock performs, the investor always receives the monthly interest payments 

Basically, there are only three possible scenarios. First, XYZ's stock price never falls below the buffer of $7.50 per share (strike price of $10 x 75% = $7.50). Second, the stock price falls below the buffer, but rises and finishes above the strike price by the end of the term. Third, the stock price falls below the buffer and finishes the term below the strike price. In the first and second scenario the investor would receive hisoriginal investment back at maturity. In the third scenario, the investor would receive shares of the underlying stock at maturity. To be perfectly clear, the investor will receive an interest payment each month no matter how the stock performs. The reverse convertibles I've bought have an annual interest rate of 9.25% to 20.0%.

Next week, we'll discuss where you can buy these investments and cover some due diligence steps you should consider taking prior to purchase.

Thanks for reading and have a great week!

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