Equity Linked Bond / Reverse Convertible Bond

Today, reading the F.A.Z, I came across this adequity-linked-bonds for equity linked bonds. These kind of products are interesting as they appeal to people’s need or demand for a high guaranteed percentage return. Everyone knows that current interest rates are close to zero, so you get a lot of regular, even university educated people who are attraced to the high yield shown in the ads (and touted with: “chance for attractive returns, equity bonds with high interest rate on DAX stocks”), but still don’t see the risks associated with them. Their brain has been conditioned to associate a yield and bond price like quote with a safe bond. And who wouldn’t want 7,50 to 8,00% for investing in solid companies such as German automakers. People always need cars.

The role your financial advisor is normally paid for is to recommend good risk-return strategies. Equity linked bonds are rarely such a tool before costs, and even less so after costs. Also they involve you selling short a put. If potential investors saw the phrase: short a put and pocket the premium (for that is what they are doing), they might think twice. The bank guaranteed high nterest rate idea on the other hand hooks the gullible and is therefor the bait. These products get advertised for a simple reason, they allow a higher margin to be pocketed by the firm, in this case Deutsche Bank.

If you look at a payoff diagramm of an equity linked bond payoff-diagram-equity-linked-bond-1you see that your profit is capped and your loss is open ended (apart from interest, i.e. the put premium). Does that sound like a good strategy to pay a bank 100-200bp for? Also note that these products have a time to maturity of 10-14 months. That’s why banks love these products. They simply offer a higher return to them. You are not getting a high enough return as an investor for the risk you’re taking.

In a derivatives lecture my professor pointed this out. One of the young german bankers got pretty aggressive at that point, and very defensive, saying that they were a good deal for the client. The professor said they weren’t. My role as your financial advisor, or of my company, is to make sure you are getting paid for the risks you take and fully aware of the pitfalls.

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