Interested in a 30%> yield with little to no risk? Some brokers and advisers are pitching retirees just such a high-gain, low-pain scenario with their latest offerings: reverse convertibles. But regulators say ignore the hype -- these so-called wonder investments may also wipe out your savings.
In the years before the market crash, reverse convertibles bond-like securities that are typically linked to the performance of a single big-name stock like Apple or Intel and offer juicy interest payments were hugely popular with individual investors. But after thousands suffered huge losses when stocks cratered in 2008, sales of these exotic investments plummeted. Now, two years into the bull market, reverse convertibles have come roaring back: In 2010, investors bought nearly $7 billion of these investments, up 55% from 2009, according to the Financial Industry Regulatory Authority.
For small investors, the allure of reverse convertibles now is the same as it was a few years back: They can provide a super-high level of income yields range from 5% to a whopping 30% -- and have a low minimum investment (typically just $1,000). But in today's challenging fixed-income market, they're even more attractive to income-hungry investors, say experts. After all, yields for most types of bonds are at historic lows. Treasury bonds, for example, yield just 3.3%, while riskier junk bonds return 7%. Meanwhile, big banks, including Barclays, Citigroup, Bank of America Merrill Lynch and JPMorgan Chase have all been issuing new reverse convertible shares over the past few months. "You can understand why these investments are so enticing to investors," says John Gannon, senior vice president for investor education for the Financial Industry Regulatory Authority. "People are seeking yield and we're in a low-rate environment."
What those investors often miss, however, is that these so-called structured products can also go south, says Gannon. Here's why: The notes are sold to regular investors in $1,000 increments and kick out regular interest payments during the term of the investment, typically three months to one year; investors get their full original investment back in cash when the note matures. But if the underlying stock plunges past a certain point -- called the "knock-in" level, usually about 20% or so -- investors are instead stuck with the fallen stock in place of the principal. For example, let's say the stock linked to your reverse convertible drops 40%, your investment morphs to shares in that stock -- now worth 40% less than their value at the time of purchase. Investors also don't benefit from any gains if that underlying stock shoots up in value. "The reality is that any one of these notes could drop significantly in value," says Andy Kapyrin, director of research at RegentAtlantic Capital, a registered investment adviser in Morristown, N.J.
In fact, the brokerage or financial services firm that issued the security is essentially betting that underlying stock will lose value, says Gannon. "Even though this looks like a bond, sounds like a bond and kind of operates like a bond, you really have a security risk that's tied to this," says Frank Fantozzi, president of Planned Financial Services, an independent financial advisory firm based in Cleveland.
What's worse, many brokers have incentives to push these products over more suitable options because they come with high fees ranging from 1% to 8% -- that are not regularly disclosed to investors, says Gannon. "The fee level is not always transparent so you're not sure exactly what the firm packaging these securities is making on the product," says Kapyrin. "It could be fairly significant and of course the more money they make, the less the investor makes." Some brokers and advisers have also targeted "unsuitable investors" (those over 85 years old or individuals with less than $50,000) for reverse convertibles, says Gannon.
While Finra confirms that there's been a spike in arbitration claims against brokers selling reverse convertibles over the past year, officials would not disclose the number or discuss ongoing cases. Today, the regulator said it was contacting several brokerage firms to request more information on how they market and sell reverse convertible notes. Back in December, an arbitration panel awarded $125,000 to a widower who lost $100,000 in reverse convertibles sold to him by a Wells Fargo broker. A Wells Fargo spokeswoman did not respond to a request for comment before press time. And in February of 2010, Finra fined H&R Block Financial Advisors $200,000 and ordered them to pay $75,000 in restitution for selling reverse convertible notes to a retired couple and allowing them to sink more than 40% of their total net worth into the risky investments. A spokesman for the company, which is now part of Ameriprise, did not respond to a request for comment. For its part, the Securities and Exchange Commission recently sent out investor alerts, warning investors to be careful about investing in derivatives, a main component of reverse convertibles. A SEC spokeswoman declined to comment.
So when do reverse convertibles make sense in your portfolio? Investors in these notes could suffer fewer losses than stock investors during a downturn because they have a guaranteed fixed coupon payment that offsets some of the loss, says Keith Styrcula, chairman of the Structured Products Association, a trade group. That said, investors should only buy them if they'd be comfortable owning the stocks linked to the notes, he adds. Also, keep your bets small. "This is not a product that should represent a large portion of your investment portfolio," says Gannon.