Reverse Convertible — high coupon isn't free money

Reverse Convertibles are the structured product that's most often missold as a "high-yield bond". They look like fixed income — pay a face value, collect a fat coupon, get repaid at maturity — but the coupon is anything but risk-free.

Mechanically, a Reverse Convertible is a bond minus a short put. The fat coupon is the put premium amortized over the life of the trade. The risk is what happens when the put gets exercised — which is exactly when the underlying crashes, i.e., the worst possible time.

The promise

You buy a Reverse Convertible at face value €1,000. The terms:

• Coupon: 8% annual (vs 3% on an equivalent vanilla bond).
• Reference asset: a stock, say BNP Paribas at €60 today.
• Strike: €60 (the conversion threshold).
• Maturity: 1 year.

At maturity, two outcomes:

• BNP closes above €60: you get back €1,000 + the coupon. Best case — high yield, full capital.
• BNP closes below €60: instead of €1,000 cash, you receive shares of BNP — at the strike price. If BNP is at €40, you get €1,000 worth of BNP at the €60 strike (= about 16.6 shares), now worth €667. Plus the coupon. Net: ~€747 instead of the promised €1,080.

Where the high coupon comes from

It's the put premium you sold. Issuer's replication:

• Buy a 1Y zero-coupon bond worth €1,000 at maturity → costs ~€970 at 3%.
• Sell a 1Y put at strike €60 on BNP → collects, say, €50 in premium.
• Net cost to issuer: ~€920.
• Issuer sells the certificate to you at €1,000 face value, packaging the €80 difference as a high coupon over the life of the deal.

You bought a long-bond + short-put portfolio. The coupon is the put premium amortized.

When does it work?

• Implied vol on the underlying is high. High IV = rich put premium = fatter coupon. Reverse Convertibles look most attractive after a vol spike (e.g., post-earnings, post-crisis bounces).
• You'd be OK owning the stock at the strike. The worst case is you end up holding the stock at the conversion price. If you would have bought it at that price anyway, the trade isn't terrible — you just pre-funded it via the bond.
• You're structurally bullish on the underlying. The coupon is your reward for confidence; the conversion is your stress scenario.

It's a sound product for someone who genuinely wants the equity exposure with extra yield, and a poisoned product for someone who thinks they're buying a bond. The label "reverse convertible" doesn't do enough to clarify which side you're really on.