What are reverse convertible bonds?

How do reverse convertible bonds (RCBs) work?

RCBs combine the regular interest payments of a bond with the price risk of the underlying financial instrument, such as a share.

During the term, you receive a fixed interest payment on the invested capital and at the end of the term, it is decided in what form and amount the capital flows back.

Since the product is based on equity risk, which can reduce the repayment amount, you will receive an above-average interest rate on your investment over the term.

Now a bit more details:

An RCB is always based on another financial instrument, which is referred to as the underlying below.

The underlying (also known as an underlying asset) can be derived from another instrument that underlies the RCB.

The more volatile the underlying asset is, the higher the coupon or interest rate that you receive on your investment amount and which is set at closing.

The repayment of the investment depends on a pre-determined price of the underlying asset, which is called a “strike” in technical jargon.

This strike is usually selected below the current price of the underlying asset in order to have a price buffer (loss buffer).

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Here is an example:

For this example, we chose an RCB with a share as an underlying asset.

The share has a current price of €100. We have set the base price at 90€ (= 90%).

For our investment, we receive an interest of 10% p.a. on our invested capital.

The term is exactly 1 year.

For example, if we invest €10,000, we will receive coupon payments of €1,000 over the term.

At NAO, this coupon is usually paid monthly, so that you receive a credit of €83.33 every month and don't have to wait 1 year for the first coupon payment.

But what happens at the end of the term after one year? Two scenarios should illustrate the repayment mechanism.

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Best case:

Let's imagine that after one year, our base value is 95€.

What happens then?

We have received coupon payments of €1,000 over the term and are now getting back the entire amount of €10,000 invested.

Why the entire amount? Because the price of the underlying asset is above the predefined base price.

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Bad case:

Imagine that after one year, our base value is 81€.

What happened?

We received coupon payments of €1,000 over the term.

Since our underlying is unfortunately below the predefined strike price, we are presented as if we had purchased the underlying at a strike price of €90 per share.

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We therefore receive 111 shares of the underlying asset, which corresponds to €9,990 at a price of €90.

We receive cash compensation for the remaining €10 that we have invested - more on that later.

Since our 111 shares are worth only 81€ per share today, this share position corresponds to the equivalent of €8,991.

This corresponds to a book loss of 10%.

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Now on to the cash settlement:

Since the shares cannot be broken down indefinitely, we receive cash settlement for theoretical fractions of shares, taking into account our book loss of the share.

We therefore receive an additional 9€ in cash.

In summary, today we look as follows:

Account balance 9€

Stock portfolio: €8,991 (10% book loss)

Total amount: €9,000

Coupon payments received: €1,000

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