Definition of Reverse Convertible Bond (RCB)

A reverse convertible bond (RCB) is a bond that can be converted to cash, debt, or equity at the discretion of the issuer at a set date. The issuer has an option on the maturity date to either redeem the bonds in cash or to deliver a pre-specified number of shares.

Understanding Reverse Convertible Bond (RCB)

A convertible bond has an embedded call option that gives bondholders the right to convert their bonds into equity at a given time for a predetermined number of shares in the issuing company. The yield on a convertible bond is typically lower than the yield on a similar bond without the convertible option because the embedded option gives the bondholder additional upside. Another type of bond with an embedded convertible option is the reverse convertible bond.

The reverse convertible bond (RCB) has an embedded put option that gives the borrower or bond issuer the right to convert the bond's principal into shares of equity at a set date. The option, if exercised, allows the issuer to “put” the bond to bondholders at a set date for existing debt or shares of an underlying company. The underlying company need not be related in any way to the issuer's business. In fact, there may be more than one underlying stock, ranging from small-cap to large-cap companies, tied to a reverse convertible bond.

Maturities and Yields

RCB securities usually have shorter terms to maturity and higher yields than most other bonds because of the risk involved for investors, who may be forced to redeem their bonds for securities in a company that has, or is expected to, decrease substantially in value. The above-market coupon is paid either monthly or quarterly. In addition to the stated coupon that is paid periodically, at maturity the investor receives either 100% of the initial investment principal in cash, or a pre-specified number of shares of the underlying stock are delivered in lieu of full cash payment, depending on the performance of the linked asset.

RCB investors do not get to participate in any upside appreciation of the underlying asset. Instead, in exchange for higher coupon payments during the life of the bond, the bondholders effectively give the issuer a put option on the underlying asset. If the price of the underlying asset linked to the bond decreases below a predetermined price, often referred to as the knock-in level, the bond issuer will exercise its right to repay the principal with a number of shares in a company, not with cash. In a case in which shares are delivered as repayment, the value of the shares will be less than the amount originally invested since the shares are with a company that is on a downslide.

If the value of the underlying asset stays above the knock-in level, the bondholders receive the high coupon payment for the life of the bond investment and the return of their full principal in cash. This is typically the best-case scenario for a reverse convertible bond investor.

Reverse convertible bonds are popular with European-based issuers. An example of a reverse convertible bond is a bond that has a period to maturity of two years and allows the bond's issuer - say, a European bank - to redeem the bond at its discretion in shares of a given blue chip by the maturity date. RCBs have high yields of around 8 to 30%.