Reverse Convertible Notes

A reverse convertible note is often sold as "a bond that pays extra income," and the "extra" part is real — but it's not free. Underneath the marketing, the investor has been paid a rich coupon for agreeing to sell a put option on a stock, bundled invisibly inside the note. If the stock stays above a set level, the investor gets principal back plus the fat coupon, like a normal bond. If the stock falls hard, they don't get cash back at maturity — they get shares of the now-cheaper stock instead, exactly as if they'd sold that put and gotten assigned.

The payoff

$$\text{Payoff} = \begin{cases} \text{Face} + \text{Coupon}, & S_T \ge \text{Barrier} \\ \dfrac{\text{Face}}{S_0} \times S_T \ + \ \text{Coupon}, & S_T < \text{Barrier} \end{cases}$$

In words: $S_0$ is the stock's price when the note was issued and $S_T$ its price at maturity; $\text{Face}$ is the note's principal amount and $\text{Coupon}$ the fixed payment, received regardless of what the stock does. If the final price $S_T$ stays at or above a barrier level, the investor gets their full principal back in cash plus the coupon — the best case. If $S_T$ falls below the barrier, the cash principal is replaced by $\text{Face}/S_0$ shares of the stock, valued at $S_T$ — so the investor's principal repayment shrinks in direct proportion to how far the stock fell, exactly as if they had bought the stock outright below the barrier, while still keeping the coupon they were paid up front.

Worked example 1 — the coupon-only scenario

An investor buys a 1-year reverse convertible with $10,000 face value on a stock starting at $50, barrier set at $40 (80% of $S_0$), coupon 9% ($900). If the stock ends at $55 (above the $40 barrier), the note pays back the full $10,000 principal in cash, plus the $900 coupon: total $10,900. That 9% looks like an extraordinary yield for a "bond" — and it is, because a normal investment-grade bond wouldn't pay anywhere near that; the extra yield is compensation for the embedded short put, which in this scenario simply expired worthless and cost the investor nothing beyond the opportunity cost of not having owned the stock outright.

Worked example 2 — the shares-instead-of-cash scenario

Same note, but the stock falls to $28 by maturity — well below the $40 barrier. The investor receives $\text{Face}/S_0 = 10{,}000/50 = 200$ shares, worth $200 \times 28 =$ $5,600 at maturity, plus the $900 coupon already paid: total value $6,500, a $3,500 loss on the $10,000 principal. Compare this to simply selling a put with strike $40 on 200 shares for a $900 premium: assigned at $40 while the stock is worth $28, that's a loss of $(40-28)\times200=$ $2,400 net of the $900 collected, i.e. $1,500 on the option alone — the note's total loss is larger because it also forgoes any return on the $10,000 principal itself.

The embedded instrument inside a reverse convertible is a short put — the note issuer is effectively the buyer, and the investor is the seller, collecting the premium (folded into the coupon) up front. Drag the strike and premium above to see the classic short-put shape: capped gain (just the premium/coupon), uncapped downside as the stock falls further below the strike/barrier.

What this means in practice

Reverse convertibles are marketed heavily to yield-hungry retail investors, and the coupon genuinely is compensation for a real risk — the embedded short put — priced by the issuing bank's derivatives desk, which delta-hedges the option side. The investor gives up all of the stock's upside above the barrier while keeping essentially all of the downside below it, a deeply asymmetric trade-off a headline "9% yield" doesn't communicate on its own.