Introduction
For most of us, liquid cash is something we are always short of. To leave some money ahead for investment is a long-term proposition or even a dream for most of us.
After allocating your salary money, towards house rent, gas, school fees for your kids, and electricity, hardly 15% of the net salary you may have received, stays on hand. Therefore, investing through a proper channel becomes a far-sighted opportunity for most households that thrive on 9-5 jobs.
As a hungry investor, what do you do now? You look for fixed deposits or bonds that can further cause a dent in your cash-flow reserves. Here is where you go for a dynamic form of investment called ‘Reverse Convertible Structured Notes’, as your investment option. Let us now see what this is all about:
A reverse convertible structured Note refers to a short-term investment that can provide investors with a steady source of income. You may receive much better yields over traditional bonds or mortgage funds.
And, RCNs (Reverse Convertible Notes) also come to you with a healthy dosage of risk. In a nutshell, investors get an even-paced and steady source of income and therefore you can add this product to your investment portfolio so that your cash reserves do not suffer anymore.
Understanding Reverse Convertible Structured Notes
A reverse structured note or an RCN is a structured product usually linked to bonds and stocks. The linkage happens when the product issuer embeds a ‘put option’ on the bond.
Investors find RCNs quite attractive as they provide high-yield income through regular coupon payments. The product also matures over a shorter duration of time.
Investors however must learn more about the market risks these RCNs are associated with. Only then, will you be able to understand the risk-return profiling of these securities.
How do RCNs Work?
Reverse Structured Notes or RCNs are coupon-bearing investments with payouts at maturity. The performance of underlying assets or stocks, the RCNs are linked to determine the level of payouts for the investor.
RCNs are usually issued by large financial corporations and banks. The RCNs mostly mature ranging from three months to one year.
If you have a look at it, RCNs are usually divided into two parts. The components are:
- A debt instrument
- A derivative whose values take the ‘put’ option
Therefore, when you purchase an RCN, you are telling the issuer that you are aware of the possibility that you may receive the underlying asset instead of the principal if the asset’s value falls below a certain level. Also, coupon payments vary from quarterly to semi-quarterly depending on the terms of the RCNs.
The performance of underlying assets would of course have a bearing on the level of coupon payments you may receive from your RCN. The market-volatility plays a significant role in the upward or downward trend of assets the product is linked to.
Investors who take higher risks have the potential to earn higher yields indeed. Not only are you assured of your original investment at the time of maturity, but you may also have enhanced coupon payments with higher risks you may take. Therefore, this is an attractive source of investment that provides yields and a reasonable level of downside protection level on your capital investment.
What Happens When the RCNs Mature?
When RCNs mature, the investor
- Receives 100% of the capital back or
- Receives a predetermined number of the underlying stock’s shares
The number of shares you receive is calculated by dividing the total value of investment by the stock’s initial price. And, that would be the number of shares you receive from the product issuing company.
Let us look further into when you can receive your original level of investment and when you can receive the shares of the underlying stock.
The payment options are divided into two structures. These are:
- A basic structure
- A knock-in structure
Let us look into each of the above:
- Basic Structure
Under a basic structure, you may receive 100% of your initial capital investment if the stock values above its initial price at the time of maturity.
On the contrary, when the value of the stock, dips below the initial price, then you may be allotted a pre-determined number of shares that is less than your overall investment.
- Knock-in structure
As you receive shares in the place of money, your shares are activated under your investment portfolio. A knock-in mechanism applies here and the value of stocks at the time of closing gets activated under your investment profile.
The put option on stocks helps you mitigate losses on your overall investment portfolio.
Within a knockin structure, when the investor handles better risk on the portfolios, he/she gets higher coupons instead of fixed coupons
Solved Examples concerning how RCNs operate
Suppose, an investor buys RCNs worth $13,000. The RCN comes to you at an 80% knock-in or barrier level. The underlying stock’s initial price is $65 per share
Scenario 1:
When the stock value reaches $52 or less but has never exceeded the knock-in price or the barrier, then the investor will receive the predetermined no of shares and that means the non-returnable of the full principal amount.
Scenario 2:
If the final price of the stock closes at $60 and does not go beyond its initial price of $65, then the value of your investment gets converted into shares. The calculation follows:
13000/ 65= 200
Therefore, even when you sell the shares, you may only receive 200*60= 12,000.
Here, you at least receive a major portion of your capital money over losing it all.
Scenario 3
When the underlying price of the stock exceeds the initial price, in other words, if the share closes at $69 or $70, the investor then receives the complete value of the investment. Here in this case the amount is $13,000.
There is an interesting piece of twist to the whole thing. Here, even if the underlying stock has breached the threshold of going $52 or below (Barrier level breach), still if the closing price of the stock is valued above its initial price ($65) the investor gets a complete value of his/her investment. In this case, the amount is $13,000.
Interest payments or coupon payments are done as stated on the initial offer document as disclosed.
Risk Factors that are Associated with RCNs
What are the risk factors associated with RCNs? Well, let us have a look into each of them:
- Credit risk
The investor is purely at the risk of the financial institution or the issuing company’s creditworthiness to get income streams in the form of coupon payments and to receive the capital amount at the time of the investment’s maturity.
- Having limited access to secondary markets
More often than not, investors may have to hold RCNs until the time of maturity. The RCNs may not trade with the underlying stock’s securities on a day-to-day basis.
However, when you try selling these notes before the term or tenure of your investment plan, then you must be ready to lose a portion of your capital. The risk involved accelerates when the underlying asset’s knock-in levels are distorted.
- Call-off options are inevitable
The product issuing companies may call on your RCN while it is generating terrific yields. When the prevailing interest rates are low, the issuing company may add marginal returns to your investment and ask you to call off your investment.
Therefore, for those of you who want to hit jackpot gains, this is an area of concern that may have concerning RCNs.
Tax implications vis-a-vis payoffs
The performance of an underlying stock whose shares rise up or down is directly proportional to the returns you earn. The RCN investment could end as regular income tax or capital gains tax. And, you may receive coupon payments only quarterly. The coupon rate over a common stock may differ from an exotic one.
Tax implications can also be a concern for investors wherein the coupon payments are taxed as regular income and only the exact value of an investment can be treated as capital gains.
The Bottom Line
Although RCNs provide higher returns on investment over traditional bonds, one must remember that you are exposed to potentially higher risks on your investment portfolio.
You may not be able to completely capitalize on the appreciation of referenced assets Therefore, your initial investment in a debt security converts into equity.
The volatility of markets plays a significant role in deciding whether you get the liquid money or a pre-determined number of allotted shares that are usually lesser than the value of your investment.
Therefore, investing in RCNs is meant for investors who have a reasonable degree of risk tolerance over newbies.
