Reverse Convertible Bond (RCB)

What Is a 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 predetermined number of shares.

Understanding Reverse Convertible Bonds (RCBs)

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 preset 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 tied to a reverse convertible bond.

Maturity and Yield Considerations

RCB securities usually have shorter terms to maturity and higher yields than most other bonds because of the risks involved for investors. Investors may be forced to redeem their bonds for securities in a company that has decreased substantially in value. The above-market coupon is paid either monthly or quarterly. In addition to interest payments, the investor receives either 100% of the initial investment principal in cash or a prespecified number of shares of the underlying stock at maturity.

RCB investors do not get to participate in any upside appreciation of the underlying assets. Instead, the bondholders effectively give the issuer a put option on the underlying assets. Investors accept this risk in exchange for higher coupon payments during the life of the bond. Suppose that the price of the underlying asset linked to the bond decreases below a predetermined amount, which is also called the knock-in level. Then, it makes sense for the bond issuer to exercise its right to repay the principal with shares rather than cash. Since an RCB leaves the conversion at the discretion of the issuer, the value of the shares will be less than the amount initially invested.

If the underlying asset price stays above the knock-in level, the bondholders receive the high coupon payment for the life of the bond. When the bond matures, they receive their full principal back in cash. That is typically the best-case scenario for reverse convertible bond investors.

Benefits of Reverse Convertible Bonds (RCBs)

The most significant advantage of RCBs is their high coupon rates. Reverse convertible bonds have high yields of between 7% to 30%, according to FINRA. That raises the question of why companies would want to pay such high rates. Often, they expect the underlying assets to decline in price. At the same time, other investors are willing to buy the underlying assets and hold them. Stockholders typically receive far less compensation from dividends than RCB investors get in interest. Buying a reverse convertible bond can be a profitable alternative to purchasing the company's stock.

Criticism of Reverse Convertible Bonds (RCBs)

Reverse convertible bonds suffer from defects similar to the problems with callable bonds but with far higher downside risk. As with callable bonds, RCBs have complicated features that protect sophisticated bond issuers at the expense of less-informed investors.

It is easy for investors to ignore the escape clauses and be drawn in by bonds promising high interest rates. In the case of callable bonds, the issuer can get out of paying high rates through refinancing if business and credit ratings improve. With reverse convertible bonds, an issuer can escape from repaying the full principal by exercising the equity conversion option. With RCBs, business and stock prices must decline for the issuer to benefit at the expense of bondholders.

The worst problem with reverse convertible bonds is that investors sometimes think they are buying an asset similar to a standard bond. What RCB buyers are really doing is selling a naked put on the underlying assets. As a general rule, investors should not buy reverse convertible bonds unless they would be comfortable owning the underlying assets.