Stock market tip: Avoid stock performance-linked bonds (the 'reverse convertibles')

Reverse convertibles enrich brokers, not investors.

“Here’s an asset class that’s basically failed on all counts...I doubt these are being pitched as an opportunity to lose 1 percent.”

- Glenn Tongue, T2 Partners

Wade into the Reverse Convertible Swamp with me for a moment...

I rarely make sweeping generalizations about any products but I'll tell you right now that these things are garbage. All of 'em.

At the old brokerage firm, we had quite a few of these smarmy wholesalers (usually from LaSalle Bank) come in and pitch us "structured products". Their tutorial slideshows and "how they work" expositions were a master course in pedantry.

But brokers all over the country sitting through these "due diligence" meetings only heard the part about the 1.6% - 2% built-in concession. The other feature they liked was the fact that every few months, the note would mature - meaning they could roll the client into the next one and collect the next fee. When you work solely on commission, having a product that guarantees future transactions is manna from heaven.

From Bloomberg:

Structured note sales rose 46 percent last year to a record $49.4 billion in the U.S., Bloomberg data show. The securities fed demand from individual investors frustrated with record low rates on everything from certificates of deposit to money market funds with the Federal Reserve holding its target interest rate for overnight loans between banks in a range of zero to 0.25 percent since 2008. Banks issued $33.9 billion in 2009, according to StructuredRetailProducts.com, a database used by the industry.

For the uninitiated, with a reverse convertible you're risking 100% of your capital to eek out like a 4% gain, betting on the range of a stock over three months. They are like bonds linked to a stock's performance over a defined period of time. You get an interest payment and then either your principle back in cash or, if the stock drops, you'll be given the shares of it at a loss.

"But that 4% annualizes out to a 16% yield!" Yeah, great.

In the meanwhile, I'm at risk to be put common stock to at a loss if the price breaks plus my interest is backed only by the faith and credit of the issuer. Guess who was one of the top 3 reverse convertible issuers in 2007? Did you say Lehman Brothers? If you did, a copy of my new book "Waffles for Dinner" is on its way out to you.

Anyway, brokers and banks sold a ton of this stuff, got big underwriting fees or selling concessions and, in many cases, explained very little to their clients...

Banks sold more than $6 billion of bonds linked to the performance of stocks last year, promising returns of as much as 64 percent at a time when interest rates were at historic lows.

Instead of reaping such extraordinary gains, reverse convertibles, as the products are known, lost 1 percent on average last year...the Standard & Poor’s 500 Index returned 8 percent during that period and corporate bonds gained 11.1 percent

The Law of Unintended Consequences is in full effect here - starve people of lower-risk yields long enough and they'll nudge themselves out onto the tightrope.

According to the Bloomberg story, regulators are now sniffing around in this swamp. Good.

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