A Steaming Stew of Toxic Bonds

With short-term interest rates pinned near zero and long rates moving downward on the prospect of more Fed money printing, conservative investors and savers are being starved of yield. These investors are busy scouring the investment landscape for opportunities to pick up yield.

The hucksters and promoters smell opportunity. If it’s yield you need, Wall Street has you covered. The Street’s financial engineers have cooked up a steaming stew of complex structured products that promise all the income you could ever want. How does an 11% yield sound? Wall Street’s peddlers can set you up with a nice double-digit-yielding reverse convertible note. Never heard of a reverse convertible? Don’t worry, I’m sure your pitchman will be happy to explain risks—that is, if he understands them.

Reverse convertible notes are wolves in sheep’s clothing. In their basic form they are nothing more than naked put options disguised as a bond. Do you sell naked put options? Do you even know how a naked put options strategy works?

I’m familiar with a reverse convertible note being offered by a large investment bank with a 10.50% annual coupon that is due in six months. This particular security is linked to the performance of Alcoa shares. You buy each note for $1,000, and the bank will pay you a 10.50% annual coupon in monthly installments, which is about 5.25% return over the six-month life of the note. So far, so good. But if Alcoa’s shares close at a price that is more than 20% below the current price at any time during the six-month life of the note, the bank can pay back your principal in shares. If Alcoa is down 20% when your reverse convertible matures, guess what? You’ve just lost 20% of your capital. How’s that double-digit yield sound to you now? And don’t expect to sell your note at anything close to par before it matures. The secondary market for this toxic waste is virtually nonexistent.

If your broker tries to pitch you structured notes, run the other way. Reverse convertibles and many of the other structured notes that Wall Street is issuing in droves are not suitable for most investors. Keep it simple. You may not like the yields on regular bonds, but you’ll like the massive losses you may incur on structured notes even less.