How to Invest With Barrier Reverse Convertibles

Barrier reverse convertibles are meant to enable you to achieve a good return thanks to high interest yields, even when markets are stagnant. This moneyland.ch guide gives you all the most important information on this topic.

What is a barrier reverse convertible?

A barrier reverse convertible (BRC) is a structured investment product that is used to optimize returns during periods when a market is stagnant. While barrier reverse convertibles share some similarities with bonds, they should not be confused with bonds, as they are derivatives that are based on underlying assets like stocks, commodities, or currencies. A BRC can be based on just one underlying asset, or on many different ones. 

BRCs typically have a predefined expiry date. Investors receive a predefined interest payment (the coupon). A BRC has a predefined threshold or barrier. Whether you make a loss or earn a return depends on how the price of the underlying asset performs in relation to the barrier. 

There are two possible scenarios for you as an investor:

• If the price of at least one of the underlying assets is below the predefined threshold (the barrier) when the BRC expires, then you only receive the underlying asset with the poorest price performance. In this case, you make a loss, because the value of the assets you get is lower than the amount you paid for the BRC.
• If the prices of the underlying assets are all higher than the threshold when the BRC expires, then you are refunded the full amount you paid for the BRC. Your return is made up of the interest you receive through the coupon. You do not receive any dividends and you do not benefit from capital gains.

The barrier usually sits at between 50 and 90 percent of the price of the underlying asset. If a BRC uses more than one underlying asset, then it may have different barriers for the different underlying assets. As a general rule, the higher the barrier is, the bigger the coupon will be – because the risk of loss is also higher.

Which kinds of BRCs are there?

BRCs can be broadly divided based on which type of barrier is used. The two most important barrier systems are:

• American barrier: The price of the underlying asset is tracked throughout the full validity period. The amount to be refunded to you can be reduced if the price of one or more of the underlying assets ever slides below the barrier at any point during the term.
• European barrier: Only the price of the underlying asset at the time that the BRC expires is relevant. Price drops above or below the barrier during the validity period are irrelevant.

The risk of loss is smaller with the European barrier system than with the American system. Resultingly, the coupons are generally smaller, so achieving a higher return requires increasing risk by accepting higher barriers.

What makes barrier reverse convertibles interesting for investors?

The coupons are what make BRCs an interesting investment vehicle. You earn a fixed amount of interest that is usually much higher than the interest you earn from savings accounts or bonds. Interest rates of nine to 10 percent are typical. The rule of thumb: The lower the barrier – and therefore the risk – the lower the interest rate. And in reverse, the higher the barrier (and the resulting risk of loss), the higher the interest rate. 

Good to know: You receive the coupon (interest) regardless of how the underlying asset performs. The interest earned can cushion at least part of a loss.

How can I invest in barrier reverse convertibles?

Barrier reverse convertibles are widely used in Switzerland, and are offered by numerous Swiss banks. Before a new BRC is issued, there is a subscription period of between four and six weeks during which you can purchase the BRC from the issuing bank. At the end of this period, the BRC is issued, and the contracts you purchased are transferred to your custody account.

Once a BRC has been issued, you can invest in it using a stockbroker. Just use your stockbroker’s search tool to find the product using its ISIN. BRCs whose validity period has already begun are always offered at their current price. Buying a BRC after it has been issued can pay off if you believe the market situation has changed in your favor.

What are the costs of investing in barrier reverse convertibles?

When you buy a BRC using a stockbroker, your stockbroker may charge you a brokerage fee. The brokerage fees for trades in structured products can be higher than those charged for stocks, bonds, and ETFs.

There is no unified fee structure for BRCs. Both the kinds of fees charged and the size of fees varies between banks. If you buy a BRC that has not yet been issued during the subscription period, the issuing bank may charge you a subscription fee. However, BRCs do not normally have ongoing fees like the total expense ratios (TERs) charged for funds.

What are the disadvantages and risks of investing in BRCs?

Investing in barrier reverse convertibles comes with various risks and disadvantages that investors should be aware of:

• Risk of loss: Investing in BRC comes with a high risk of loss. The success of your investment depends on just a handful of underlying assets – a few different stocks, for example. You can very quickly lose a lot of money. The higher the barrier is, the higher the risk of loss is. In the worst case scenario, the underlying asset could lose all of its value, and all you will get back is the coupon.
  Potential returns are limited: The highest possible return you can earn with a BRC is limited to its coupon. You do not receive possible gains in the price of the underlying asset (a stock, for example), nor do you receive dividends.
• Complexity: The way in which BRCs are structured can be very difficult for inexperienced investors to understand.
• Counterparty risk: Like other structured products, a BRC simply represents a claim against its issuer. Unlike ETFs, barrier reverse convertible contracts are not securities, but simply debt claims that can become worthless if their issuer becomes insolvent. Because of the counterparty risk, it is advisable to pay careful attention to issuers’ creditworthiness when looking at BRCs to invest in. 

How profitable are barrier reverse convertibles?

There is no single answer to this question because the return varies depending on which barrier reverse convertible you use. The return is determined by the coupon because – assuming the underlying assets surpass the barrier – the interest you earn will be your profit on the transaction. So a BRC’s coupon is the highest possible return you can earn. Even if the underlying asset massively gains in value over the contract term, you will never receive more than the predefined coupon.

The size of a BRC’s coupon depends on how big the risk of loss is. Interest rates in excess of five percent are commonplace, but it is not unusual to find interest rates exceeding 10 percent for BRCs with a higher risk of loss. Factors that play a role in determining the risk of loss include:  

• The height of the barrier: The higher the barrier is, the higher the risk of loss is, and the higher the coupon will be.
• The type of barrier used: BRCs that use the American barrier system have a higher risk of loss than those which use the European barrier system. In exchange, the coupon is also higher.
• Which underlying assets are used: The risk of loss also strongly depends on which underlying assets are used for the barrier reverse convertible. The risk is higher when a BRC has multiple underlying assets because there is a bigger chance that one of the underlying assets will fall below the barrier.

Who can benefit from using barrier reverse convertibles?

Barrier reverse convertibles are generally complicated products. They are best suited to experienced investors with high risk tolerance who expect markets to move sideways but still want to earn a good return. If you expect the price of an asset to climb, then it normally makes more sense to buy the stock, bond, or other asset directly rather than using a BRC.

Using BRCs is generally not advisable for inexperienced investors. These products are complicated, and come with a risk of loss that should not be underestimated. If an underlying asset falls past the threshold, the interest you earn from the coupon may not be sufficient to cover the resulting loss.

Disclaimer: This article is published for informative purposes only, and should not be considered as investment advice. The publishers do not accept any liability in connection with this publication.

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