A Put by Any Other Name--Reverse Converts

An article on page C1 of The Wall Street Journal on June 16 entitled "Reverse Converts: A Nest Egg Slasher" discusses these securities, which are commonly marketed as bonds. However, these investments are actually a duck in turkey clothing. Duck is perfectly appropriate if you are expecting it, but it can be shocking if you are served a duck dinner when you are expecting turkey.

The article discusses reverse convertibles bonds, which are marketed as securities with bondlike characteristics that "morph into stocks when the underlying share price plunges." Regular readers of Morningstar's option content will recognize a security that generates a nice yield but that may wind up with you owning shares of stock. These are exactly the characteristics of a cash-secured put option. In fact, if it looks like a duck, and it quacks like a duck, in this case, it is simply a duck.

A couple of years back, I actually received a call from the fixed income desk of my retail brokerage about one of these securities. I can't recall the details of the underlying company, but the broker offered to sell me a "bond" that paid some double-digit percentage annualized return over six months, as long as the stock didn't fall more than 20%. If the stock fell further, I would simply own the stock. I declined the offer as I would any inbound call from a broker, but I did say, "So, you're asking me to write a put on company XYZ." I recall that my comment generated a sheepish response. I also remember calling my representative at the brokerage and explaining that it was fine that the bond desk call me with such creations, but that I hoped that there were suitability constraints that prevented the company from marketing these to "widows and orphans" who didn't understand their characteristics.

Now that we've joined The Wall Street Journal in thoroughly shaming the brokerage industry, let me take a step back. There is actually nothing wrong with a cash-secured put option or reverse convert. As a buyer of one of these "bonds," you are actually putting your cash up as insurance on the stock price in exchange for an insurance premium. If the stock stays flat or rises, you get to keep the insurance premium plus your cash. If the stock price falls, you wind up owning the shares at a predetermined price. At Morningstar, we think of this as "selling the downside," or selling downside exposure to the stock. We are actually quite fond of this type of transaction, as the market often offers huge insurance premiums to sell the downside on fundamentally sound companies, often with economic moats. This high-volatility environment actually raises the value of the put options while lowering the value of many sound companies, making put-selling strategies particularly attractive. In fact, even superinvestor Warren Buffett has been selling puts recently. You can read about his put transactions in this recent article. The key to success in this type of investing is to understand that the long-run downside is limited to the value of the company you are considering, and to be willing to hold the shares of the stock underlying the reverse convert if the shares should be put to you. If you are secure that the company is worth more than the strike price of the reverse convert, you can collect the premium secure in the knowledge that you'll own the shares at a good price and that you'll generate a return on the shares as that is the price you may be forced to buy them.

For example, the article discusses reverse converts that pay around 11% over one year on companies like  Apple Inc.  (AAPL),  Celgene Corp. , and  Johnson and Johnson (JNJ). By going to Morningstar's option chains for Apple, and opening the January 2011 data, we see that the put options at the current price of Apple shares pay about 12% annualized.

If a broker calls you offering to sell you a reverse convert, you should know that the security is nothing more than a cash-secured put. The reverse convert may be a good investment as long as you understand the risk profile, you are comfortable with the long-run value of the company, and you are willing to hold the shares if necessary. If you are considering such an investment, you can check the annualized premium as calculated on Morningstar's option chains for an option with the same strike/stock value as the strike price of the reverse convert. The annualized premium should be similar to or less than what you are getting paid on the bond, or you should consider writing the cash-secured put yourself. Keep in mind that the annualized premium is calculated on a continuously compounded basis, and the number you are being quoted may be a simple interest number, which may be a bit higher. In fact, if you are approved for option trading, you can "roll your own" reverse convert by writing cash-secured puts on any company with a limited downside and put options traded with a long enough horizon.

If you are interested in further exploring this strategy, I'd encourage you to download a free copy of The Morningstar Guide to Option Investing.

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