Reverse Convertibles or Flex® Put Sale?

In today’s low interest rate environment, reverse convertibles have been popular in the structured note market as they are one avenue where investors can achieve outsized yields. Reverse convertibles are structured notes, typically on single stocks, where the investor receives periodic coupon payments, but runs the risk of purchasing shares at above-market levels at maturity. They are not principal protected.

Investors who buy reverse convertibles are essentially buying a zero coupon bond on the issuer + selling a knock-in put (an exotic type of option). The coupon payments of the reverse convertible are almost entirely derived from the sale of the knock-in put (a very small portion is derived from the credit risk of the issuer). A knock-in put does not become active until a pre-determined barrier level is breached. A typical knock-in put embedded within a reverse convertible might have a 100% strike with a barrier level that is 20% below that strike. For instance, if a stock is trading at $100, the strike would be $100; if the stock closes any day during the life of the contract under $80, the put becomes active and sellers of the put may have to purchase stock at $100 at maturity.

CBOE does not list knock-in puts – they can only be traded in the over-the-counter market. However, selling a standard put option has similarities to buying a reverse convertible. Today we’ll compare and contrast buying a reverse convertible against selling a standard put option.

A bank issued a 3-month reverse convertible on May 26 on luluemon athletica inc (ticker = LULU; May 26 closing price = $91.75). It matures on August 30, 2011 and pays a monthly coupon; the per annum interest rate is 21%. The note has a 20% barrier level. This means that if LULU closes 20% lower ($73.40) on any day during the 3-month time period and settles below the original 100% strike($91.75) at maturity, then note holders will be obligated to purchase shares at the 100% strike (meanwhile, they will keep their monthly coupons – which are akin to option premium collected).

In order to compare this reverse convertible to options that are available at CBOE, we need to find a LULU option that would also yield 21% per year. We would want to use European-style options rather than American as we don’t want to give the long option holder the opportunity to exercise early. Standard LULU options are all American style and currently offer expiries in July and September. But we can create a LULU option via FLEX that expires on the same date as the reverse convertible (August 30, 2011). Moreover, we can specify that this LULU option contain European-style settlement rather than American-style. All that’s left is finding the strike that would yield a return of 21% per year.

Using interpolated implied volatilities from standard American-style LULU options in July and September, I’ve determined that a European-put expiring on August 30, 2011 that is struck 11% out-of-the money would yield a per annum return of 21%. Like the reverse convertible, we are using the May 26 closing price of $91.75. Therefore, our FLEX put strike would have been $81.66 (11% OTM). With a 50% implied volatility, this put is worth $4.67. So if we sold 1 contract, we would collect $467. In a cash securities account, we would be required to put up the put strike amount ($8,166) as that is the level where we are obligated to purchase LULU shares. The premium collected on the FLEX put matches the yield of the coupon payments in the reverse convertible.

So should investors use the reverse convertible or the downside FLEX put?

  • Investors in the reverse convertible are unsecured debt holders of the issuing bank; the FLEX option is issued by the AAA-rated Options Clearing Corporation.
  • While the reverse convertible has more “protection” on the downside (20% vs. 11%), there are significant differences should either be exercised – the note holder would be obligated to purchase shares at $91.75 while the short put holder would be obligated to purchase shares at $81.66.
  • Investors in the FLEX put would have to luxury of multiple liquidity providers to choose from should they desire to exit the trade prior to expiration. Note holders would likely be limited to liquidity offered by the issuing bank only.
  • The premium collected from the FLEX put sale is credited to your account on the initial trade date, while the coupon payments of the reverse convertible are spread out over the life of the note.

Ultimately, the decision would rest on your view of how much downside cushion is necessary, your comfort level in being an unsecured debt holder of the issuing bank, and the likelihood of closing the position prior to expiration. Regardless, investors should be aware that FLEX provides them with similar opportunities to reverse convertibles.