Looking back: 25 years of the rev conv

This is the story of how the reverse convertible came to life at a time when structured products were known as ‘special products’ in the Swiss market.

This is the story of how the reverse convertible came to life at a time when structured products were known as ‘special products’ in the Swiss market.

It was in the spring of 1998, and Swiss (and US) interest rates were already low – the great crisis of the year 2000 would arrive two years later…

That is how Patrick Oberhaensli, founder and CEO of EVOLIDS FINANCE, a disruptive Swiss financial services company, recalls the market environment in the run up to the debut of the first ever reverse convertible structure in the Swiss market.

Oberhaensli has been teaching finance to professionals since 2009 and was previously responsible for Swiss institutional sales at Robeco for over five years. Prior to that, he held various senior client-oriented positions at Swiss Bank Corporation (SBC) which was merged with Union Bank of Switzerland (UBS) in 1998 to form UBS – the largest bank in Europe and second largest in the world.

“I was working at internal audit investment banking when I was offered to move to the client front within investment banking. This is where I started working on interest rate derivatives at a time when structured products were called ‘special products’ there,” says Oberhaensli.

In that context, he had a strong focus on product development and creating new solutions.

“A lot of our work at the time involved looking at interest rate curves in different currencies but also at the assets classes to find cross-market opportunities,” he says.

It was during his time at UBS when Oberhaensli started working with options which led to the creation of the first reverse convertible structure.

Investor driven

The design of the first rev conv structure had nothing to do with internal conversations but with feedback from institutional investors which were seeking to go beyond the classic short-term views on companies (bonds/stocks) related to tactical asset allocation or the ones associated with (long term) strategic asset allocation.

“Institutional investors wanted to have an (alternative) neutral medium-term view for those investing directly on specific sectors and specific names and were looking at a different type of exposure which at the time could only be achieved by directly investing in equity or leveraging these (the directional view),” says Oberhaensli.

This approach was problematic because there wasn’t a suitable solution if the investor had a view that a specific stock or sector would not move a lot in the mid-term - three to fiveyear horizon – as “there were no exchange-traded options that would last that long.

“Another key element that pushed me to find a solution was that most institutional investors cannot use leverage and that made the situation more difficult,” Oberhaensli says. “We had to simplify and have those considerations embedded in an all-inone investment solution that would make things clearer in terms of exposure.”

The rev conv structure is based on implementing a view on the underlying instrument but without leverage and with a mediumterm horizon which is something investment banks could offer over-the-counter (OTC), although banks would not want to have credit exposure versus the investor.

“To have something that was fully capitalised from the beginning we resorted to options to build that new type of structured product,” he says.

“That is how the first reverse convertible structure on stocks and later on bonds came to life. This yield enhancement strategy became popular among investors because it was fulfilling a need."

According to Oberhaensli, the main driver was the investor view and then understanding what makes the short put exposure from the investor perspective more valuable.

“Essentially, what makes a short put worth more than is volatility on one side, but also the dividend yield which adds more value to the put which is then sold at higher price,” he says.

“Understanding out of the universe of stocks you can filter out using these two criteria, especially. But you can of course add other filtering elements that would ensure to get closer and match what the investor wants.”

Of course, adds Oberhaensli, some reverse convertibles on certain underlyings with less attractive coupons on the flow side will have less demand.

“But on the investor solutions side they play a valuable role in a portfolio,” says Oberhaensli.

From institutional to retail

Reverse convertibles have had an interesting evolution over time. On one hand, the more exotic the option the less volume of issuance will likely be possible. On the other hand, there are several elements to consider at the same time with this structure “as you must match the view on the asset with the typically shorter time horizon and the partial capital protection will necessarily lead to a lower coupon (than without that partial capital protection)”.

According to Oberhaensli, there's no contradiction in the transition from institutional to retail as the rev conv is a structure that has added value to private banking and retail investors as well.

“Of course, investing in such a product should be preceded by an investment policy statement [IPS] so that the product matches the investment objectives and constraints of the end client,” says Oberhaensli. “That is why I think this product is not a flow product but a solution type of product – it’s not something that should be taken from the shelve but be aimed at solving a need. From that perspective it still has the profile of an institutional product.”

The main attractive of the rev conv is that is built upon a very simple and easy to explain structure which of course can become complex with the use of exotic options.

“The simplicity of the reverse convertible certainly played an essential role in its wide adoption,” says Oberhaensli, pointing at the three key elements in a rev conv - understanding the structure, the opportunity and the associated risks.

“Essentially, investors are delta long in the underlying, and depending on the structure you need to also consider the credit risk of the bond - nowadays alternative issuing vehicles have become more common (with their own risks).”

The success of the rev conv is closely linked to its payoff profile which resonated with bond investors that understood the embedded credit risk of the issuer while accepting the stock's specific risk.

According to Oberhaensli, demand for the reverse convertible will not fade because in the current environment of higher volatility and higher interest rates this payoff structure can offer good returns depending on the underlying and the investment horizon.

“There are opportunities in numerous stocks all the time and very special situations that can make reverse convertibles more attractive,” he said. “The US debt ceiling controversy for example could potentially trigger a sharp(er) volatility spike for a while.

“On the other hand, we know that volatility is mean reverting, and you also have to consider the put call parity as a call warrant issued on the same underlying, horizon and strike will lead to a price benefit given that hedging the risk is much easier.”