Reverse Convertible Note (RCN)

What is a Reverse Convertible Note (RCN)?

A reverse convertible note (RCN) is a financial product that shares characteristics with bonds and stocks. A bearing coupon investment, it offers a payment at maturity that depends on the performance of an underlying stock. Structured as short-term, high-yield investments, most RCNs have maturities of three months to two years.

Key points to remember

  • A reverse convertible note is a coupon-bearing investment that offers a payment at maturity that depends on the performance of an underlying stock.
  • The potential reward can come at a high cost. RCNs generally have a high level commission costs and are considered by some fund managers to be very risky, even toxic assets.

How a Reverse Convertible Note (RCN) Works

Reverse convertible notes have a face value that matures in stock or cash, at the option of the issuer, and a fixed bond-based coupon rate. RCNs are often touted as a way for investors to diversify their portfolios without buying both stocks and bonds. The court maturity period and the potential for high returns attract most investors looking for relatively quick rewards. However, investors must tolerate the level of risk involved.

The potential reward can come at a high cost. RCNs generally have high commission fees and are considered by some fund managers to be very risky, even toxic assets.

Risks and Considerations of Reverse Convertible Notes

The adage “Buyer beware” is something investors should consider when investing in RCNs. Their complicated setup can be confusing to the average investor, who may not fully appreciate the risks involved. The lure of attractive yields and quick maturity can distract investors and cause them to overlook important caveats and drawbacks of RCNs.

If the stock linked to your RCN loses value when the maturity date arrives, the principal you receive may be less than the value of the note. The investor could end up with a bunch of stocks worth much less than expected. Even if they sell the stock quickly, they will suffer a loss, possibly a significant one. Along the way, the investor looking for quick gains will incur high costs.

The Financial Industry Regulatory Authority (FINRA) has issued several alerts that detail the risks associated with RCNs. At least one of these alerts was prompted by FINRA enforcement action, including one instance in which the agency forced a brokerage firm to pay more than $1.4 million in fines and restitution for “supervisory failure resulting in the sale of inappropriate reverse convertibles.”

There are also tax implications to consider, which, as with other aspects of NCBs, can be complex. Due to the way Reverse Convertible Notes (RCNs) are formed, they are subject to special tax treatment. The returns you see from your RCN investments could be subject to both capital gains tax and income tax.