If you're an income-hungry investor, a stagnating stock market or crumbling yields on certificates of deposit, money markets and bonds can put a big dent in your cash flow. When this happens, there's a short-term investment idea that you might want to consider: reverse convertible notes (RCNs). These securities provide a predictable, steady income that can outpace traditional returns - even those of high-yield bonds. Read on to learn more about them, and how to add them to your portfolio.

Tutorial: The Basics Of Bonds

RCN 101
Reverse convertible notes are coupon-bearing investments with payouts at maturity; and, they are generally based on the performance of an underlying stock. The maturities on RCNs can range from three months to two years.

The notes are usually issued by large financial institutions. However, the companies whose stocks are linked to the RCNs have no involvement at all in the products.

RCNs consist of two parts: a debt instrument and a put option. When you buy an RCN, you are actually selling the issuer the right to deliver the underlying asset to you at some point in the future. (Find out how a put option works in How is a put option exercised?)

How Payouts Are Determined
Before maturity, RCNs pay you the stated coupon rate, usually in quarterly payments. This constant rate reflects the general volatility of the underlying stock. The greater the potential volatility in the stock's performance, the more risk the investor takes. The higher the risk, the more you get for the put option. This translates into a higher coupon rate.

When the RCN matures, you'll receive either 100% of your original investment back or a predetermined number of the underlying stock's shares. This number is determined by dividing your original investment amount by the stock's initial price.

There are two structures used to determine whether you will receive your original investment amount or the stock:

  • Basic Structure - At maturity, if the stock closes at or above the initial price, you will receive 100% of your original investment amount. If the stock closes below the initial price, you'll get the predetermined number of shares. This means you'll end up with shares that are worth less than your original investment.
  • Knock-In Structure - You'll still receive either 100% of your initial investment or shares of the underlying stock at maturity. With this structure, though, you'll also have some downside protection.

For example, suppose your $13,000 RCN investment includes an 80% knock-in (or barrier) level, and the underlying stock's initial price is $65. If, during the term, the stock never closes at $52 or less, and the final price of the stock is higher than the knock-in price of $52 and you'll get your original investment of $13,000 back.

Figure 1: A reverse convertible note that doesn\'t close below the knock-in level.

If it had closed at $52 or less at any time during the life of the investment and the final price is lower (let's say $60) than the initial price of $65, you'll get the predetermined amount of stock, which would be $13,000/$65 = 200 shares. This would only be worth $12,000 if you sold those shares at that time.

Figure 2: A reverse convertible note that falls below the knock-in level

If the underlying stock had closed higher than the initial buying price of $65, you would get your initial investment back in the end, regardless of whether the $52 threshold was broken.

Figure 3: A reverse convertible note that closes higher than the initial buying price

As discussed above, investing in RCNs involves the risk of losing part of your principal at maturity. In addition, you don't participate in any increase in the underlying asset's value above the initial price; therefore, your total return is limited to the stated coupon interest rate.
What's more, there are a few other risks that you should be aware of before you invest in RCNs:

  • Credit Risk - You are relying on the issuing company's ability to make interest payments during the term and pay you the principal payment at maturity.
  • Limited Secondary Market - You must be willing to accept the risk of holding the RCN until maturity. However, the investment firm that issued the RCN will usually try to maintain a secondary market. However, this is not guaranteed; understand that you may get less than your original cost if you sell.
  • Call Provision - Some RCNs include a feature that could take your RCN from you just when it's kicking out terrific yields and prevailing interest rates are low.
  • Taxes - Because RCNs consist of two parts, a debt instrument and a put option, your return could be subject to capital gains tax and ordinary income tax.

What Type of Investor Is Suited for an RCN?
RCNs could be suitable for investors looking for the predictable, higher income streams than can be found on traditional fixed-income investments and can tolerate the risk of losing some of the principal. Investors should only buy into RCNs when they believe that the underlying stock will not drop below the knock-in level. Keep in mind that the companies who sell these investments are betting that the stock price will drop below the set barrier, or at least be volatile enough to make this a possibility.

With higher risk there should be higher potential reward, and this is true for RCNs. After all, where else can you invest as little as $1,000, get a double-digit yield on your money, and only tie it up for a relatively short time? But don't think that RCNs are an alternative to your CDs - the principal is not guaranteed. In addition, you should be comfortable with the RCN's underlying company because you could end up with shares of its stock when your RCN matures, so be sure to read the offering circular and prospectus carefully before investing. Finally, you should only invest in RCNs if you understand the ins and outs of options. (For more on options, read the Options Basics Tutorial.)

Related Articles
  1. Mutual Funds & ETFs

    The 3 Best T. Rowe Price Funds for Value Investors in 2016

    Read analyses of the top three T. Rowe Price value funds open to new investors, and learn about their investment objectives and historical performances.
  2. Active Trading Fundamentals

    4 Stocks With Bullish Head and Shoulders Patterns for 2016 (PG, ETR)

    Discover analyses of the top four stocks with bullish head and shoulders patterns forming in 2016, and learn the prices at which they should be considered.
  3. Fundamental Analysis

    3 Reasons To Not Sell After a Market Downturn

    Find out the reasons that it is not a good idea to sell after a market downturn. There are lessons to be learned from the last major market downturn.
  4. Fundamental Analysis

    HF Performance Report: Did Hedge Funds Earn Their Fee in 2015?

    Find out whether hedge funds, which have come under tremendous pressure to improve their performance, managed to earn their fee in 2015.
  5. Sectors

    2016's Most Promising Asset Classes

    Find out which asset classes are considered to be the most promising for generating portfolio returns and reducing volatility in 2016.
  6. Mutual Funds & ETFs

    3 Morgan Stanley Funds Rated 5 Stars by Morningstar

    Discover the three best mutual funds administered and managed by Morgan Stanley that received five-star overall ratings from Morningstar.
  7. Mutual Funds & ETFs

    3 AllianceBernstein Funds that Are Rated 5 Stars by Morningstar

    Discover the top three mutual funds administered and managed by AllianceBernstein that have received five-star overall ratings from Morningstar.
  8. Retirement

    Is it Safe for Retirees to Invest in Technology?

    Tech stocks are volatile creatures, but there are ways even risk-adverse retirees can reap rewards from them. Here are some strategies.
  9. Mutual Funds & ETFs

    Is Morningstar’s Star System An Effective Ranking Tool? (MORN)

    Learn why Morningstar's star rating system is not always a great predictor of future performance, and why investors should not pick funds on star ratings alone.
  10. Stock Analysis

    The Top 5 Oil and Gas Stocks for 2016 (XOM, BP)

    Read detailed analyses of the top five oil and gas stocks, and learn why they may be poised to rise in 2016 after a dismal 2015.
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  3. What is securitization?

    Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming ... Read Full Answer >>
  4. Can hedge funds trade penny stocks?

    Hedge funds can trade penny stocks. In fact, hedge funds can trade in just about any type of security, including medium- ... Read Full Answer >>
  5. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
  6. How do mutual funds work in India?

    Mutual funds in India work in much the same way as mutual funds in the United States. Like their American counterparts, Indian ... Read Full Answer >>
Hot Definitions
  1. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  2. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  3. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  4. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  5. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
Trading Center