How to find the right reverse convertible bond
Investors should develop a differentiated market assessment before buying, because the reverse convertible is not suitable as an investment vehicle for strongly rising or sharply falling markets – in the first case the profit is limited to the coupon, in the second case the repayment of the capital becomes uncertain. With regard to their individual risk tolerance and expected return, investors can orientate themselves on two parameters: the position of the base price in relation to the current share price and the (remaining) term.
The lower the base price is chosen, the lower the interest coupon and possible maximum return; At the same time, however, the greater the tolerance for one’s own forecast errors. Even a negative share price development can still be cope with with a reverse convertible bond with a low base price without incurring capital losses. Even a very low base price is no substitute for capital protection.
If, on the other hand, the share has good price potential and does not expect a downturn at the end of the term, you can optimize your earnings by choosing a strike price that is at or above the current price. The increased willingness to take risks leads to a higher maximum return.
Extra tip: With the term of a reverse convertible bond, its earnings potential generally increases. However, investors should keep in mind that a reverse convertible securitizes a short put position based on the receipt of an option premium – and thus benefits from the loss of time value of options. According to the option price formula, this does not accrue linearly over the option term, but is highest in the last three months.
From an empirical point of view, price increases on stock markets usually take place slowly and continuously, while losses are often violent and rapid: the better the course of business of a company can be predicted, the lower the uncertainty about its future and the lower the market will estimate its volatility. Rising prices are therefore often accompanied by decreasing volatility, falling prices by increasing volatility. For the synthetic, covered short put position in a reverse convertible bond, this can mean that positive effects from rising prices are intensified by falling volatilities. Conversely, falling stock prices can have a double negative impact.
Before deciding on a particular reverse convertible bond, you should always ask yourself the following questions: