Despite losing ground to Auto-calls as the high yield structured product of choice, Reverse Convertibles retain decent market share. For this article we will define Reverse Convertibles as being income seeking structured products with a fixed maturity and which are capital at risk through the presence of a European or American barrier.
The two types of reverse convertible
Two main types of Reverse Convertible exist, those that pay fixed unconditional income through the life of the product and those that have contingent income, typically which gets paid if all underlyings are above a coupon barrier level. For example a product may be linked to a single stock and have a European barrier of 60% which determines whether it will repay full capital. The fixed income version might pay a coupon of 10% at a given frequency such as quarterly. The contingent income version instead could pay a (higher) coupon of 12% but only if the underlying is above a barrier (perhaps at 70%) at each coupon date. It is easy to see that other things being equal, the investor would expect to get a higher coupon rate for the contingent or barrier version because the coupon is not certain.
For Auto-calls the use of the coupon barrier (sometimes named “Phoenix”) is very common and accounts for a big share of that sector. However, for Reverse Convertibles the use of contingent coupons is less common as we will now analyse.
The Auto-call product type has achieved blanket coverage in many markets and its enticing blend of returns, timing and protection have made it very popular.
There are many similarities between Reverse Convertibles and capital at risk Auto-calls. Both aim for yield and the typical capital return at maturity is often the same: full capital unless a barrier level has been breached in which case the return of the product is equal to the level of the underlying asset price return.
Why Auto-calls are different
However there are two key differences in the payoff profile of the two product types. The Reverse Convertible is designed to produce income whereas many Auto-calls pay a return only once called. The other difference is that the reverse convertible has a fixed maturity and an Auto-call by construction is likely to mature early in any positive scenario.
Therefore when comparing an Auto-call with a reverse convertible with the same maximum maturity, underlying and final barrier level the headline yield for the Auto-call is significantly higher, often nearly twice as much as could be offered for a reverse convertible. These optics and payoff characteristics are part of the reason that Auto-calls have long replaced reverse convertibles as the yield instrument of choice in the structured products world.
The rationale for Auto-calls is to aim for high yield defined in the loosest sense: either through income or a fixed returns when the product is called. Calling typically occurs when the market has achieved its target, which can be equal to, higher or lower than the initial levels of the underlying. Most Auto-calls have reasonable capital protection and are well suited to a portfolio approach of investment diversified by underlying or timing. Because of the inherent uncertainty in Auto-calls, barrier conditions on any income payment are not viewed as unreasonable or adding to the complexity.
However Reverse Convertibles are aimed more at traditional income seeking investors who want the certainty of income even though they are prepared to take some capital risk. Alternatives outside structured products for these investors include corporate bonds, convertible bonds and high yielding equities. All of these have reasonably certain income streams with some capital risk.
It would therefore be illogical and unacceptable to most income seeking investors to have potential income that could be completely missed for one or more income periods which could occur if a coupon barrier is present. There is a high auto-correlation effect too, once a coupon has been missed the underlyings would require growth in order to pay income again.
Therefore there is a high risk that income would remain unpaid for a significant period. For many true income seeking investors this trade off in order to boost the headline yield would make the product unappealing.
In a MiFID II world in Europe as well as best practice in other markets distributors may be nervous about promoting a product which carries significant liability and reputational risk by failing to deliver on its key rationale.