March 26, 2008
DOW JONES REPRINTS
Risky Strategy Lures Investors Seeking Yield
Popular 'Reverse Convertibles' Offer Lucrative Payouts But Could Cause Steep Losses
By ELEANOR LAISEMarch 26, 2008; Page D1
Wall Street is luring income-hungry investors with complex securities that come with big risks as well as extravagant yields.
The products -- called "reverse convertibles" -- are typically linked to the performance of a single stock like Apple Inc. or AT&T Inc. and often offer yields ranging from 7% to as high as 25% or more. Sales on these notes have been soaring as yields on many fixed-income investments have been sinking. Small U.S. investors snapped up $8.5 billion worth of reverse convertibles in 2007, up 81% from 2006, according to Arete Consulting LLC, which tracks the products.
At Incapital LLC, a distributor of reverse convertibles, sales doubled in 2007 from a year earlier, says Chief Executive Tom Ricketts. The notes are issued by firms such as Morgan Stanley, Barclays PLC and ABN Amro Holding NV. The companies whose share prices are linked to reverse convertibles have no involvement in the products.
For small investors, reverse convertibles offer a high level of income for a low minimum investment. But investors typically don't participate in any gains in the underlying stock, and if the stock falls sharply, they can lose much of their investment. Regulators have grown increasingly concerned about how complex "structured products" such as reverse convertibles are marketed to small investors, and they're pushing issuers to closely monitor their sales practices.
The products can be lucrative for issuers. They usually come with hefty fees, often in the range of 2% to 3% or more, which are typically priced into the yield investors get. The issuer's ultimate profit varies depending on how it hedges against the risk of issuing the note.
Here's how a typical reverse convertible works: The notes are sold in $1,000 increments and offer 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 -- except under certain circumstances tied to a set "barrier" level.
If the price of the underlying stock falls below that level -- typically a drop of 20% or more -- during the note's term and then finishes below the initial stock price, investors get beaten-down shares of stock instead of cash. If the stock is down 50%, for example, they get shares worth half of their original investment.
Because of this, reverse convertibles are particularly dangerous when linked to volatile stocks. But higher volatility makes it easier for Wall Street firms to create reverse convertibles with enticing yields. Buyers of reverse convertibles are essentially selling a "put" option on the underlying stock, which obligates them to buy the shares if they sink by a certain amount. The riskier the stock, the more the put option is worth -- and the higher the yield that reverse convertibles can pay investors.
Some observers say that things are going to get rougher. As markets get choppier, "you'll increasingly [see] investors get burned on reverse convertibles," says David Krein, president of DTB Capital, a New York investment adviser that specializes in structured products.
Indeed, a growing number of reverse convertibles are leaving investors with beaten-down shares. In September, investors bought reverse convertibles linked to Countrywide Financial Corp. with a yield of 22%. The problem is that Countrywide's share price sank more than 70% by the time the notes matured in mid-March. Bottom line: Investors lost more than half of their money, even after interest payments.
The situation looks far bleaker with reverse convertibles issued by Barclays that were linked to Bear Stearns Cos. and yield 12.3%. Bear's stock traded well over $100 when the notes were issued in late October, but has since dropped roughly 90%. If shares remain at the current price, investors stand to lose much of their money.
Issuers maintain that reverse convertibles, despite the risks, still offer investors attractive terms. "A lot of investors don't believe there is a whole lot of upside in the equity markets these days," so they don't mind giving up gains in the underlying stocks' share price, says Kevin Woodruff, head of North America equity derivatives at Morgan Stanley.
But some investors who had success with reverse convertibles while stocks were rising are now feeling pain. Sue Chiodo, 54 years old, of Bartlett, Ill., plowed about one-third of her portfolio into them when she retired as a sales manager for a software company about five years ago. She was attracted by the high yields and was happy with the way the notes performed -- but lately many of the investments have soured.
Taking a Beating
Last June, she bought a reverse convertible linked to InterOil Corp. with an initial price of $42.50 yielding 31%. But within a few days, the stock had plummeted more than 50%, and Ms. Chiodo ultimately wound up with the devalued shares, which now trade at about $20. Some of her more recent reverse-convertible investments aren't turning out much better. "I'm holding some right now that ... yuck," she says. "I'm going to take a beating."
There are other issues with the products. Investors who try to sell a reverse convertible before maturity may have trouble recouping their original investment. While many issuers maintain a secondary market in reverse convertibles, there may not be much demand for the notes -- especially in a down market.
Late last year, the Financial Industry Regulatory Authority -- formed by the merger of the National Association of Securities Dealers and a New York Stock Exchange regulatory arm -- sent structured-products providers inquiries about their marketing and sales practices. Massachusetts Secretary of State William Galvin charged one firm with failing to properly supervise its brokers selling structured products.
"My guess is most retail people don't walk in off the street and say, 'Do you have any reverse convertibles?' " says Marc Menchel, Finra's executive vice president and general counsel. "My guess is in most cases they're recommended to retail [investors]."
Alternatives to CDs?
Brokerage firms sometimes liken reverse convertibles to far safer investments. FISN Inc. lists reverse convertibles under "CD Alternatives" on its Web site. But an investor in a certificate of deposit gets federal deposit insurance up to $100,000, whereas a reverse-convertible investor takes on far more risk. FISN President Tom Coan says the site isn't misleading. Reverse convertibles "are alternatives to CDs," he says. "They pay fixed income."
In 2005, the NASD suggested that firms consider limiting sales of structured products to investors approved for options trading. But even relatively sophisticated investors can run into trouble with reverse convertibles.
Jeanne Libit, 57, of Great Falls, Va., a former CPA who is comfortable shorting stocks and trading options, started investing in reverse convertibles about two years ago because interest rates were "pathetic," she says. She has bought about 10 reverse convertibles so far, and only about half of them gave her full investment back in cash at maturity.
Ms. Libit lost roughly $7,000 or $8,000 of her $20,000 investment in one note linked to Advanced Micro Devices Inc. -- and that's only because she used other strategies like buying put options and shorting to mitigate her risk in the stock. If she hadn't done that, she figures she would have lost about $12,000 or $13,000.
"When they go south on you, they go south quickly," she says.
Write to Eleanor Laise at eleanor.laise@wsj.com1
URL for this article:http://online.wsj.com/article/SB120648718371963833.html
DOW JONES REPRINTS
Risky Strategy Lures Investors Seeking Yield
Popular 'Reverse Convertibles' Offer Lucrative Payouts But Could Cause Steep Losses
By ELEANOR LAISEMarch 26, 2008; Page D1
Wall Street is luring income-hungry investors with complex securities that come with big risks as well as extravagant yields.
The products -- called "reverse convertibles" -- are typically linked to the performance of a single stock like Apple Inc. or AT&T Inc. and often offer yields ranging from 7% to as high as 25% or more. Sales on these notes have been soaring as yields on many fixed-income investments have been sinking. Small U.S. investors snapped up $8.5 billion worth of reverse convertibles in 2007, up 81% from 2006, according to Arete Consulting LLC, which tracks the products.
At Incapital LLC, a distributor of reverse convertibles, sales doubled in 2007 from a year earlier, says Chief Executive Tom Ricketts. The notes are issued by firms such as Morgan Stanley, Barclays PLC and ABN Amro Holding NV. The companies whose share prices are linked to reverse convertibles have no involvement in the products.
For small investors, reverse convertibles offer a high level of income for a low minimum investment. But investors typically don't participate in any gains in the underlying stock, and if the stock falls sharply, they can lose much of their investment. Regulators have grown increasingly concerned about how complex "structured products" such as reverse convertibles are marketed to small investors, and they're pushing issuers to closely monitor their sales practices.
The products can be lucrative for issuers. They usually come with hefty fees, often in the range of 2% to 3% or more, which are typically priced into the yield investors get. The issuer's ultimate profit varies depending on how it hedges against the risk of issuing the note.
Here's how a typical reverse convertible works: The notes are sold in $1,000 increments and offer 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 -- except under certain circumstances tied to a set "barrier" level.
If the price of the underlying stock falls below that level -- typically a drop of 20% or more -- during the note's term and then finishes below the initial stock price, investors get beaten-down shares of stock instead of cash. If the stock is down 50%, for example, they get shares worth half of their original investment.
Because of this, reverse convertibles are particularly dangerous when linked to volatile stocks. But higher volatility makes it easier for Wall Street firms to create reverse convertibles with enticing yields. Buyers of reverse convertibles are essentially selling a "put" option on the underlying stock, which obligates them to buy the shares if they sink by a certain amount. The riskier the stock, the more the put option is worth -- and the higher the yield that reverse convertibles can pay investors.
Some observers say that things are going to get rougher. As markets get choppier, "you'll increasingly [see] investors get burned on reverse convertibles," says David Krein, president of DTB Capital, a New York investment adviser that specializes in structured products.
Indeed, a growing number of reverse convertibles are leaving investors with beaten-down shares. In September, investors bought reverse convertibles linked to Countrywide Financial Corp. with a yield of 22%. The problem is that Countrywide's share price sank more than 70% by the time the notes matured in mid-March. Bottom line: Investors lost more than half of their money, even after interest payments.
The situation looks far bleaker with reverse convertibles issued by Barclays that were linked to Bear Stearns Cos. and yield 12.3%. Bear's stock traded well over $100 when the notes were issued in late October, but has since dropped roughly 90%. If shares remain at the current price, investors stand to lose much of their money.
Issuers maintain that reverse convertibles, despite the risks, still offer investors attractive terms. "A lot of investors don't believe there is a whole lot of upside in the equity markets these days," so they don't mind giving up gains in the underlying stocks' share price, says Kevin Woodruff, head of North America equity derivatives at Morgan Stanley.
But some investors who had success with reverse convertibles while stocks were rising are now feeling pain. Sue Chiodo, 54 years old, of Bartlett, Ill., plowed about one-third of her portfolio into them when she retired as a sales manager for a software company about five years ago. She was attracted by the high yields and was happy with the way the notes performed -- but lately many of the investments have soured.
Taking a Beating
Last June, she bought a reverse convertible linked to InterOil Corp. with an initial price of $42.50 yielding 31%. But within a few days, the stock had plummeted more than 50%, and Ms. Chiodo ultimately wound up with the devalued shares, which now trade at about $20. Some of her more recent reverse-convertible investments aren't turning out much better. "I'm holding some right now that ... yuck," she says. "I'm going to take a beating."
There are other issues with the products. Investors who try to sell a reverse convertible before maturity may have trouble recouping their original investment. While many issuers maintain a secondary market in reverse convertibles, there may not be much demand for the notes -- especially in a down market.
Late last year, the Financial Industry Regulatory Authority -- formed by the merger of the National Association of Securities Dealers and a New York Stock Exchange regulatory arm -- sent structured-products providers inquiries about their marketing and sales practices. Massachusetts Secretary of State William Galvin charged one firm with failing to properly supervise its brokers selling structured products.
"My guess is most retail people don't walk in off the street and say, 'Do you have any reverse convertibles?' " says Marc Menchel, Finra's executive vice president and general counsel. "My guess is in most cases they're recommended to retail [investors]."
Alternatives to CDs?
Brokerage firms sometimes liken reverse convertibles to far safer investments. FISN Inc. lists reverse convertibles under "CD Alternatives" on its Web site. But an investor in a certificate of deposit gets federal deposit insurance up to $100,000, whereas a reverse-convertible investor takes on far more risk. FISN President Tom Coan says the site isn't misleading. Reverse convertibles "are alternatives to CDs," he says. "They pay fixed income."
In 2005, the NASD suggested that firms consider limiting sales of structured products to investors approved for options trading. But even relatively sophisticated investors can run into trouble with reverse convertibles.
Jeanne Libit, 57, of Great Falls, Va., a former CPA who is comfortable shorting stocks and trading options, started investing in reverse convertibles about two years ago because interest rates were "pathetic," she says. She has bought about 10 reverse convertibles so far, and only about half of them gave her full investment back in cash at maturity.
Ms. Libit lost roughly $7,000 or $8,000 of her $20,000 investment in one note linked to Advanced Micro Devices Inc. -- and that's only because she used other strategies like buying put options and shorting to mitigate her risk in the stock. If she hadn't done that, she figures she would have lost about $12,000 or $13,000.
"When they go south on you, they go south quickly," she says.
Write to Eleanor Laise at eleanor.laise@wsj.com1
URL for this article:http://online.wsj.com/article/SB120648718371963833.html
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