Buy a Reverse Convertible? Sure! What Is It?

To hear that the securities firm RBC Capital Markets got rung up by the regulator Finra over sales of "reverse convertibles" raised a couple of interesting questions, beginning with: What is a reverse convertible?

I held several securities licenses including the Series 24 principal's license up through the middle of 2012 and I am not sure I've ever before heard the term. After digging into it, the next question is why any firm, RBC included, ever sold these things to individuals.

It's hard to even describe what they are in plain terms. Basically it's a bond and it pays interest, but at the maturity date how much principal you get back is tied to another asset, such as a stock or basket of stocks. If the value of that other so-called "reference security" has fallen below a certain level -- known as the "knock-in" level -- then the investor won't get back all their principal in cash.

What they do get back might be stock or other in-kind securities, too, worth a lot less than they thought they would be getting back in principal.

These securities have been one of Finra's concerns for years, and RBC has been far from the only firm that's been in the news for having issues arise from how they were sold.

At RBC, Finra found that the firm failed at the management level to have the processes in place to ensure that sales of these things met the test of suitability. This concept of suitability means the registered representative has to suggest an investment that is "suitable" for the investor, given all sorts of things including the customer's income and investment objective.

Given that these reverse convertibles were complex, they would only be offered to people who had an income above $100,000, liquid assets of at least $100,000 and total net worth of at least $250,000.

Even for investors the brokerage industry could properly pitch, it's still puzzling why they would want to invest in a bond that could turn into junk stocks at the maturity date. There are probably just two logical explanations.

One is that reverse convertibles pay higher rates of interest than other bonds, and so in a very low interest rate environment savers are always eager to hear about investment ideas that pay more in interest.

The other is that the customers had no idea what they were really buying.

These two explanations are, of course, very closely related. Many investors never heard or have forgotten the most basic rule of thumb for investing: any investor getting higher rates of return on an investment has taken more risk.

Even if there were any exceptions to this rule of thumb, and higher returns were available with the same level of risk as plain-vanilla bonds, what's the chance that you are going to be offered a piece of this deal by your friendly rep at RBC?