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Reverse convertible securities

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Reverse convertible security or reverse convertible is a short-term note linked to an underlying stock. The security offers steady stream of income due to the payment of a high coupon rate. At maturity, the investor will receive either 100% of his original investment amount or a predetermined number of shares of the underlying stock, in addition to the stated coupon payment.

Features

  • Short-term coupon bearing notes, structured to provide enhanced yield while participating in certain equity-like risks.
  • Investment value is derived from underlying equity exposure, which is paid in the form of fixed coupons.
  • Investors receive full principal back at maturity if the Knock-in Level is not breached (which is typically 70-80% of the initial reference price).
  • The underlying stock, index or basket of equities is defined as Reference Shares. However, in most cases, Reverse convertibles are linked to a single stock.

You may also find Inverse Reverse Convertibles, which are the opposite to a Reverse Convertible. Client benefits so long the underlying does not go above a predetermined barrier. If the underlying has breached the barrier, customer will receive principal minus the percentage of the movement against him.

Structured Products are sophisticated instruments and carry a significant risk of loss of capital

Reference Shares

  • Underlying stocks or basket of equities can include names such as:
    • Dell
    • Wal-Mart
    • Exxon Mobil
    • Cisco
    • Best Buy
    • Corning
  • Broad market indices may include names such as:
    • Nasdaq-100 Index

How do Reverse Convertibles work?

  • Short-term investments, typically with one year maturity.
  • At maturity, investors receive either 100% of their original investment or a predetermined number of shares of the underlying stock, in addition to the stated coupon payment.
  • The investors’ earning potential is limited to the security’s stated coupon, because investors receive coupon payments regardless of the performance of the underlying reference shares.
  • Coupon payments are the obligation of the Issuer and are paid on a monthly or quarterly basis.
  • Sold by prospectus or offering circular and pricing term sheet. The prices on these notes are updated intra day to reflect the activity of the underlying equity.
  • General rule of thumb:

The higher your coupon payment, the greater likelihood of receiving stock at maturity.

  • NOTE: Whether or not the Knock-in Level is breached, the investor will receive fixed periodic coupons through the term of the notes.

Delivery at Maturity

At maturity, there are 2 possible outcomes:

  • Cash Delivery
    • Stock closes at or above the Initial Share Price upon valuation date, regardless of whether the stock closed below the Knock-in Level during the holding period. OR stock closes below the Initial Share Price, but has never closed below the Knock-in Level.
  • Physical Delivery
    • Underlying shares closed below the Knock-in Level at any time during the holding period and does not trade back up above the Initial Share Price on valuation date (4 days prior to maturity).

Physical Delivery

  • Initial Share Price is determined on Trade Date.
  • The final valuation of the shares is based on the closing price of the Reference Shares determined 4 days prior to maturity.
  • If the investor is delivered physical shares, their value will be less than the Initial Share Price, however, investors are not required to sell their shares at prevailing market prices.

Secenario 1 - Cash Delivery

Reference share closing price is above the Initial Share Price of the note on Valuation Date (4 days prior to maturity), regardless of whether the stock closed below the Knock-in Level. Investor receives Cash Delivery Amount (Par), at maturity.

Scenario 2 - Cash Delivery

Reference share closing price is below the Initial Share Price of the note on Valuation Date (4 days prior to maturity), but never closed below the Knock-in Level. Investor receives Cash Delivery Amount (Par) at maturity.

Secenario 3 - Physical Delivery

Reference share closing price is below the initial price of the note at valuation date (4 days prior to maturity), and has closed below the downside Knock-in Level during the holding period. Investors receive Physical Delivery Amount, or shares of stock, at maturity. Predetermined number of shares delivered to the investor if closing price of reference shares below initial price.

Physical Delivery Amount = (Original Investment Amount / Initial Price of Underlying Asset),

Liquidity

  • Generally created as a buy and hold investment.
  • Issuers typically provide liquidity in the secondary market.
  • The secondary market price may not immediately reflect changes in the underlying security.
  • Liquidations prior to maturity may be less than the initial principal amount invested.

Trading

  • Trade flat and accrue on a 30/360 basis or actual/365
  • End of day pricing posted on Bloomberg and/or the internet.
  • Pricing will fluctuate intraday.
  • Reverse Convertibles are notes that are registered with the SEC

Ratings

  • These are an unsecured debt obligation of the issuer, not the reference company thus it carries the rating of the issuer.
  • The creditworthiness of the issuer does not affect or enhance the likely performance of the investment other than the ability of the issuer to meet its obligations.

Taxes

  • For tax purposes Reverse Convertibles Notes are considered to have two components:
    • A debt portion.
    • A put option.
  • At maturity, the option component is taxed as a short-term capital gain if the investor receives the cash settlement. In the case of physical delivery, the option component will reduce the tax basis of the Reference Shares delivered to their accounts.
  • Investors should consult their own tax advisor prior to investing. Refer to the Note’s prospectus for more detailed information.

Investor Benefits

  • Enhanced yield.
  • Current income
  • Downside protection, typically up to 10-30% on most Reverse Convertible offerings.
  • The bid-ask spread is typically 1%.
  • $1,000 minimum investment.

Risk to Consider

  • Owners of the Reverse Convertible Notes may be exposed to the risk of the decline in the price of the reference shares during the term of the note.
  • Investments in equity-linked notes may not be suitable for all investors.
  • Investors selling notes prior to maturity may receive a market price which is at a premium or a discount to par and may not necessarily reflect any increase or decrease in the market price of the underlying equity to the date of such sale.
  • Reverse Convertibles do NOT guarantee return of principal at maturity.
  • In addition, Reverse Convertibles do not have the same price appreciation potential as the reference shares because at maturity the value of the note may not appreciate above the initial principal amount.
  • The market price of the Reverse Convertibles may be influenced by unpredictable market factors.

Investor Suitability Profile

  • High net worth clients seeking current income.
  • Traditional Equity Customers.
    • Trust accounts
    • Money managers
    • Qualified accounts
    • Non-profit organizations
  • Investors that believe the markets will be relatively flat.
  • Current equity linked notes investors.
  • Investors who own the underlying stock.
  • Notes purchased at original issue will not subject to wash sale rules on the underlying stock.

See also

External links

  • US Structured Investments - A public website that acts as a portal for information on structured investments created for the US market. A free service that does not require registration.
  • Structured Products Association - The official global website of the 2,300-member Structured Products Association, the New York-based trade association for the structured products community.
  • US Structured Products - A public website that acts as a portal for information on structured products created for the US market. A free service that does not require registration.
  • UBS Structured Investments - A website that provides educational materials related to reverse convertible notes and other structured investments as well as details on issuances of UBS Structured Investments.
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