Reverse Convertible Note (RCN): What It is, How It Works

What Is a Reverse Convertible Note (RCN)?

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

How a Reverse Convertible Note (RCN) Works

Reverse convertible notes have a face value which matures as shares or cash, whichever the issuer chooses, and a fixed coupon rate based on bonds. RCNs are frequently touted as a way for investors to diversify their portfolios without buying both stocks and bonds. The short maturity period and potential for a high-yield payoff appeal to most investors looking for relatively quick rewards. However, investors must tolerate the level of risk involved.

The potential reward may come at a hefty cost. RCNs typically have high commission fees and are considered by some money managers to be highly risky and 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 returns and a quick maturity may distract investors and cause them to overlook important caveats and downsides of RCNs.

If the stock tied to your RCN drops in 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 stock worth much less than expected. Even if they sell the stock quickly, they will take a loss, possibly a big one. Along the way, the investor looking for quick gains will incur hefty fees. 

The Financial Industry Regulatory Authority (FINRA) issued several alerts which detail the risks involved with RCNs. At least one of those alerts was prompted by FINRA enforcement actions, including one case in which the agency forced a brokerage firm to pay more than $1.4 million in fines and restitution for “supervisory failures resulting in sales of unsuitable reverse convertibles.”

There are also tax implications to consider, which, as with other aspects of RCNs, can be complex. Because of the way reverse convertible notes (RCNs) are set up, they are subject to special tax treatment. Returns you see from your RCN investments could be subject to both capital gains tax and income tax.