Tutorial: Reverse convertibles

What are reverse convertibles?

Reverse convertibles are linked to the performance of a share. Through this coupling, it is possible to achieve a coupon, which is higher than the market rate. In return for the interesting coupon, the investor bears the equity risk, because at the end of the term, the price of the underlying is decisive for the redemption of the reverse convertible bond. If at the end of the term the price of the share exceeds its strike price, the coupon and the nominal amount are repaid. If at the end of the term the share price is below the strike price, then the initially fixed number of shares per nominal amount will be delivered in addition to the coupon.

Protect reverse convertibles are also linked to the performance of a share. In addition to the strike price, protect reverse convertibles also have a barrier (= protect). This additional protection against moderately falling prices means that the coupon is slightly lower than that of traditional reverse convertible bonds. If at the end of the term the price of the share exceeds its strike price, the coupon and the nominal amount are repaid. If the share price is below the strike price at the end of the term, the barrier offers an additional risk buffer (= protect). If the barrier has not been touched or broken during the term, 100% of the invested capital and the coupon will be paid. However, if the barrier has been touched or broken, a physical delivery of the shares or cash settlement will occur depending on the structure of the protect reverse convertible. The coupon will be paid in any case.

In addition to reverse convertibles with single underlyings, there are also reverse convertible bonds, which have several underlyings. In most cases, multi protect reverse convertibles pay a higher fixed coupon due to the increased equity risk. For this type of bond, the redeemable share is the one with the weakest performance at the end of the term. Regardless of the nature of the repayment, a fixed coupon is also payable here.

How do reverse convertibles work?

Investors who do not expect strong price movements but sideways markets will have the opportunity to obtain an interesting fixed coupon with a reverse convertible bond. In return, the income potential is limited to the coupon. In the environment of favorably valued stock markets reverse convertibles offer a very interesting investment opportunity.

Your benefits

With a reverse convertible bond or a protect reverse convertible, investors can achieve above-market returns in sideways or slightly correcting equity markets. The barrier to protect reverse convertibles offers additional protection against moderately falling prices up to the set barrier.

Your advantages

At the end of the term, regardless of the performance of the underlying, the coupon will be paid.
Redemption is at 100% of the nominal amount upon maturity, if the barrier has never been touched (protect reverse convertibles), or is again above the strike price at the end of the term; or if the price of the underlying is above the strike price on the final valuation date (reverse convertible bond).
If on the final valuation date the price is below the strike price, the bond will be in redeemed in physical delivery of share (which may recover to their original value later on).
The built-in barrier of protect reverse convertibles offers a risk buffer (= protect). This way investors can generate a positive return even when prices are falling (up to the barrier).
The loss in case of a cash settlement is never greater than the loss that would result from a direct investment in the stock.
Reverse convertibles and protect reverse convertibles offer the the chance to generate an interesting return despite low interest rates and sideways markets.

Risks you should be aware of

During the term price fluctuations are possible, which means that selling the reverse convertible prior to maturity may result in a loss.
By an allocation of shares, the value of the shares is less than the face value of the bond. There is no protection against capital loss.
Profit is capped by the coupon even if the underlying shows a better performance.
If the barrier is touched or broken by the underlying, protect reverse convertibles may be redeemed in shares.
Investors bear the risk of the issuer (Erste Group Bank AG).
Capital loss up to total loss of invested capital is possible.
In case of several underlyings the risk of capital loss depends on the underlying with the worst performance. There is no risk diversification despite several underlyings in the basket.
Reverse convertibles are not covered by any deposit guarantee scheme. The investor is exposed to the risk that Erste Group Bank AG may not be able to meet its obligations arising from the reverse convertible in the event of insolvency or over-indebtedness or from an official order (bail-in regime). A total loss of invested capital is possible.

How do reverse convertible react to…

… rising underlying prices?
If the price of the underlying share rises, the price of the bond rises as well because the redemption at 100 % of the nominal amount is becoming more likely.

… stable underlying prices?
With stable underlying prices the investor benefits from the fixed coupon and the redemption at 100 % nominal amount at maturity. The stable price has very little influence on the value of the bond, but the value of the bond rises as the remaining period to maturity shortens.

… falling underlying prices?
If the price of the underlying share falls, the price of the bond falls as well because the redemption by means of physical delivery of the share is becoming more likely. The fixed coupon is paid in any case.

Payoff-Chart

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