How does a reverse convertible note enhance yield and what is the investor actually selling?

Question

AcadiFi · Accepted Answer

A reverse convertible is essentially a high-yield bond plus a short at-the-money put on a single stock. Suppose Coastway Bank issues a 1-year reverse convertible on Kairos Pharma at $50 with a 12% coupon. The investor receives $120 in coupons on $1,000. At maturity: if Kairos is above $50, investor gets $1,000 back; if Kairos is at $38 (24% decline), investor receives 20 shares of Kairos worth $760 — a loss of $240 plus the $120 coupon, net $120 loss on the trade. ```mermaid flowchart LR A[Investor
$1000] --> B[Reverse
Convertible] B --> C[High-Yield
Bond] B --> D[Short ATM Put
on Stock] D --> E[Put Premium
Funds Coupon] C --> F{Stock at
Maturity} F -->|Above Strike| G[Cash $1000] F -->|Below Strike| H[Receive Shares] ``` The high coupon comes from the put premium the investor implicitly sold. Reverse convertibles typically reference volatile single stocks because higher volatility means higher put premium and thus higher coupon. Risks include: (1) concentration in one name, (2) forced equity delivery at bad prices, (3) issuer credit risk. Appropriate for investors with a neutral-to-bullish view on the underlying who wouldn't mind owning the shares at the strike price.

How does a reverse convertible note enhance yield and what is the investor actually selling?

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