Reverse Convertibles are having the Reverse Effect on Client Profitability – Boca Raton, Florida Arbitration and Litigation Attorney:

In 2010 banks sold in excess of $6 billion of bonds linked to the performance of stocks, promising substantial returns far exceeding CD and money market rates. The promised returns were generally even more than could be expected from standard bond funds or standard yields on bonds themselves. This was at a time when interest rates were at historic lows. Hence the attractiveness of the investments.

However, instead of receiving the promised returns, reverse convertibles, according to data compiled by Bloomberg on 1,481 of the securities sold last year that matured by November 30, 2010 lost, on average, 1 percent. The Standard & Poor’s 500 Index returned 8 percent during that period and corporate bonds gained 11.1 percent, including reinvested interest, Bank of America Merrill Lynch index data show.

Barclays Plc, based in London, and UBS AG in Zürich led more than a dozen banks selling reverse convertibles, which are short-term bonds generally marketed to individuals that convert into stock if a company’s share price plummets. The securities are being created as part of a boom in structured notes, or bonds packaged with derivatives whose values are derived from assets including stocks, bonds, currencies and commodities, or from events such as changes in interest rates.

Structured note sales rose 46 percent, in 2010, to a record $49.4 billion in the U.S., Bloomberg data show. Banks issued $33.9 billion in 2009, according to StructuredRetailProducts.com, a database used by the industry.

Royal Bank of Scotland Group Plc sold $1.15 million in three-month notes tied to Eastman Kodak Co. on June 10. 2010 that paid 24 percent annualized interest, a filing with the U.S. Securities and Exchange Commission shows. Purchasers could not lose money unless shares of Kodak fell to below $3.54 from $5.06. On August 31, 2010, Kodak dropped to $3.50 per share. The Royal Bank of Scotland converted the bonds into stock and investors lost about 18 percent even with the high interest rate.

What is usually not explained either fully or partially to an investor is that they might end up with stock as opposed to their principal back. Obviously, if the conversion is made the higher interest rate payment also stops. What exacerbates the problem for the investor is that reverse convertibles are not traded on exchanges, their performance is not reported publicly and they are unsecured.

Another major issues which investors must take into consideration when considering a reverse convertible is that banks charge fees as part of the transaction, which will effect yield. For example, the three month reverse convertibles sold the Royal Bank of Scotland, which were linked to Kodak, paid brokers a 2.75 percent commission.

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