Structured products sound so benign, so safe, so -- well -- structured. They’re not.
In fact in terms of where they fall on the risk scale, they’re in the same category as options, which are considered high risk and are actually linked to many structured products.
So when an unsuspecting investor hears about a structured product, which is really a derivative and usually takes a Ph.D. in mathematics to understand, and that it’s sort of a bond linked to the performance of stocks that could return as much 64 percent at a time when interest rates are historically low, then he just might take notice.
That’s what happened, according to Bloomberg, with a structured product known as a reverse convertible, and we’re not talking about a ragtop that goes backwards.
These reverse convertibles are tricky little devices and this time they ended up doing a double reverse on the investors who bought them by losing value even when the stocks they were linked to went up. And that’s not so easy to do.
Bloomberg news says banks sold more than $6 billion worth of reverse convertibles with the promise of extraordinary gains and even though Standard & Poors’ 500 index of stocks gained 8 percent and corporate bonds gained 11.1 percent, the reverse convertibles managed to lose an average of 1 percent.
Banks market reverse convertibles as short-term bonds that convert into stock if a company’s share price drops. They’re part of the recent boom in structured notes, or bonds packaged with derivatives whose values are derived from other assets that could include stocks, bonds, currencies and commodities, or even from events such as changes in interest rates.
According to Bloomberg, structured note sales rose 46 percent percent last year to a record $49.4 billion in the U.S. They seemed to fill a demand from individual investors who were frustrated with record low rates on everything from CDs to money market funds.
Barnkrate.com says the Royal Bank of Scotland, RBS, sold $1.15 million in three-month notes tied to Eastman Kodak on June 10 that paid 24 percent annualized interest or 24 times the average rate on one-year CD.
Buyers couldn’t lose money unless shares of the camera maker fell to below $3.54 from $5.06. Guess what? Kodak dropped below $3.54 to $3.50 on August 31 in New York trading and RBS converted the bonds into stock costing investors an 18 percent loss even with the high interest rate.
According to Bloomberg, reverse convertibles aren’t traded on exchanges and their performance isn’t reported publicly but investors lost $27 million on the $2.19 billion worth of the securities.
A closer look
The SEC is reportedly looking into whether the banks are charging excessive fees. Banks typically charged 1.6 percent on a three- month reverse convertible, or about six percent. In comparison, the average annual fee on stock mutual funds is one percent. The three-month reverse convertibles sold by RBS and linked to Kodak paid brokers a 2.75 percent commission. One investment expert said it may have been the fees that caused the losses.
Professional money managers generally don’t buy reverse convertibles because they can pay less in fees by trading derivatives directly.
Perhaps the worst story tied to reverse convertibles happened to a retired Sun City Center, Florida, couple. According to Bloomberg, Leroy and Carol Conklin were pitched an investment in reverse convertibles by a broker at H&R Block Financial Advisors. Conklin, who is 80 years old, said they bought the reverse convertibles as if they were corporate bonds and because they paid nine percent which he thought was a good investment.
However, when the notes converted into stock, the Conklins lost more than $130,000. Carol Conklin said she still has no idea what derivatives are. They’ve filed an arbitration claim and a hearing is scheduled for May.
Joseph Borg, director of the Alabama Securities Commission, told Bloomberg that state regulators are seeing an influx of concerns and complaints from individual investors about structured products, including reverse convertibles. He added that brokers who sell the investments sometimes don’t even understand them.