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Created on 03.07.2019

Barrier reverse convertibles for yield enhancement

Yield enhancement products are attracting considerable interest in a challenging environment for investors, with markets that are stagnating or experiencing only a slightly rising trend. Given the consistently low interest rates, investors are wondering how to achieve stable, attractive yields at an acceptable level of risk.

Barrier reverse convertibles (BRC) – or equity-like bonds – appear to be a possible answer. They are among the most popular structured products in Switzerland in the yield enhancement product category. You can find out more about structured products in the article “Structured products to supplement your portfolio”.

Barrier reverse convertibles are precisely this type of instrument: BRC have one or more underlyings (such as a basket of shares or indices) and a fixed coupon. This means that the value of the coupon is determined on purchasing the structured product and is paid out regularly, irrespective of how the underlying performs. As the name says, a barrier is also a part of the construction. The fate of the capital invested in a BRC by the investor depends on whether this barrier is listed at or below the barrier at any point during the term.

Different scenarios with or without a barrier event

In principle, there are three potential scenarios:

Scenario 1

No barrier event occurs. The investor recovers 100% of their investment as well as the coupon.

Scenario 2

If a barrier event has occurred, the underlying trades above the initial fixing (barrier event) at the end of the term. The investor recovers 100% of their investment as well as the coupon. 

Scenario 3

The underlying trades at or below the initial fixing (barrier event) at the end of the term. The investor receives the underlying delivered physically to them with the cost price equal to the strike price. This is governed via the conversion ratio for each BRC. The fractions that result from the division of the denomination amount by the strike price per share are paid out in cash. The investor also receives the coupon.

Potential returns in fluctuating markets

As well as low interest rates, investors are faced with volatile equity markets. Structured products offer a certain degree of potential returns in line with the investor’s individual risk appetite and expected yield. In the case of barrier reverse convertibles (BRC), they are also attractive due to the payment structure: the coupon is determined when the structured product is launched and is then paid out regularly, irrespective of the performance of the underlying. In markets that are stagnating or slightly declining, this often puts BRC at an advantage compared to direct investments in shares. Investors do not benefit from share investments until prices rise or dividends are distributed.

Not entirely risk-free

This unquestionably attractive aspect of BRC also involves risks, however. When prices rise significantly, direct investments in shares have an advantage over barrier reverse convertibles (BRC), whose returns are restricted to a fixed coupon and term. If, at the end of the term, the price of the underlying is higher than the initial price, the investor still recovers only the initial investment amount and the coupon. Investors do not benefit from price gains or any potential dividend distributions from the underlying.

The conditional capital protection no longer applies if the price of the underlying breaches the barrier during the term.

Look beyond the coupon

Customers must therefore expect to have securities in their custody account at the end of the term. They cannot assume that the barrier will resist. For this reason, investors should consider whether they want to bear the potential share risk before investing in BRC. Concentrating solely on the potentially attractive coupon would be too one-sided; the issuer risk, i.e. the creditworthiness of the issuer, must also be taken into account. This can be achieved firstly by selecting products from a variety of issuers. Secondly, the risk can be reduced by deliberately selecting products from an issuer with a good credit standing.

Unlike investment funds, BRC and structured products in general are not regarded as segregated assets. If the issuer were to go bankrupt, the capital invested in BRC would not be protected. Consequently, the choice of issuer should not be underestimated.

Investment options for connoisseurs

In general, BRC are suitable for investors who are familiar with structured products and expect the underlying to experience stagnation or a slight rise / decline in price. Anyone who wants to invest in BRC should also consider whether the underlying share would suit their portfolio. If these preconditions are met, BRC represent an attractive yield enhancement opportunity.

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