Fed Chief Bernanke told a group of congressmen a few days back that the Federal Reserve was going to keep interest rates low until the economy got on a firmer footing. This, of course, is great for banks but lousy for retirees and ultra-conservative savers who are earning almost nothing for putting their money to work in Treasuries, CDs and money market funds. Low rates also leads to perfectly normal people doing silly things with their money and investing into areas that they think they understand but they really don’t until it is too late.
I am writing about Reverse Convertible Notes. They sound like convertible bonds but they’re not. Convertible notes are big ticket commission items and lots of unsuspecting people are snapping them up thinking they’re going to get double digit returns but the truth being they’d be lucky to get their principal back.
Convertible Notes are equity investments coupled with a short-term note. They are the opposite of what fixed income investors would be buying if they really knew what it was they were buying.
Here’s how they work: An investor buys a one year reverse convertible note for $10,000 and it is ‘linked’ to ABC stock. (It can be any stock listed on the exchange. Usually it is a company that is well recognized in name but most amateur investors are unfamiliar with the company stock.) Let’s assume that ABC stock at the time the investor buys the note is trading at $10.00 per share. The bank or brokerage firm promises the investor a 15% return. If the price of ABC stock at the end of the one-year maturity date is at or above the $10.00 a share price then the investor gets his or her $10,000 plus interest of $1,500.
But, if the price of ABC is below the $10.00 at the maturity date, let’s say it falls to $5.00, the investor gets the number of shares of ABC that he could have bought at the time of his investment plus the interest of $1,500 for a total of $6,500.
There are also more complex arrangements with convertible notes but they all boil down to the same thing, most conservative investors don’t understand what they are buying. The odds, depending on the structure, can be on the losing side rather than on the winning.
Investment managers, with fingers and toes crossed, say there is nothing wrong with this investment as long as savers are aware that they may receive stock rather than principal. Easy for them to say. Not too many investment professionals would be buying these investments for their parents retirement account or for their kid’s education fund. Once the stock ends up in the hands of the unsuspecting ‘fixed income’ saver they then have the additional problem of having to hold the stock for an extended period of time and pay a sales commission to sell, if and when it reaches its original price.
Don’t think professional managers are immune from the possible losses of convertible notes. The government of Singapore Investment Corporation recently lost $5 billion, of an $11 billion investment, buying 9% convertible notes tied to UBS.
Bottom line is to avoid investing in what you don’t understand no matter how good it sounds. If you have questions call your advisor to see if the product is what it is before you plunk down some hard earned cash.
If you have questions on anything contained in this blog write to Paul Stanley pstanley@westminsterfinancial.com or call 877 783 7080.
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