Banks sold more than $6 billion of bonds linked to the performance of stocks last year, promising returns of as much as 64% at a time when interest rates were at historic lows.
Instead of reaping such extraordinary gains, reverse convertibles, as the products are known, fell 1% on average, according to data compiled by Bloomberg on 1,481 of the securities sold in the U.S. last year that matured by Nov. 30. The Standard & Poor's 500 index returned 8% during that period and corporate bonds gained 11.1%, including reinvested interest, Bank of America Merrill Lynch index data shows.
"Here's an asset class that's basically failed on all counts," said Glenn Tongue, a money manager who oversees about $200 million with Whitney Tilson at T2 Partners LLC in New York. "I doubt these are being pitched as an opportunity to lose 1%."
Barclays PLC, based in London, led more than a dozen banks selling reverse convertibles, which are short-term bonds generally marketed to individuals that convert into stock if a company's share price plummets. The securities are being created as part of a boom in structured notes, or bonds packaged with derivatives whose values are derived from assets including stocks, bonds, currencies and commodities, or from events such as changes in interest rates.
Structured note sales rose 46% last year, to a record $49.4 billion in the U.S., according to Bloomberg data.
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% since 2008.
Barclays sold $757.4 million of reverse convertibles in 588 offerings in the U.S. last year that matured by Nov. 30, the most of any bank, Bloomberg data shows. Investors lost about 2% on average. Kristin Friel, a Barclays spokeswoman, declined to comment.
Banks issued $33.9 billion in 2009, according to StructuredRetailProducts.com, a database used by the industry.
Royal Bank of Scotland Group PLC sold $1.15 million in three-month notes tied to Eastman Kodak Co. of Rochester, N.Y., on June 10 of last year that paid 24% annualized interest, a filing with the Securities and Exchange Commission shows. That's 24 times the average rate on one-year certificates of deposit, according to data from Bankrate Inc. in North Palm Beach, Fla.
Buyers couldn't lose money unless shares of the camera maker fell to below $3.54, from $5.06. Kodak dropped to $3.50 on Aug. 31 in New York trading. RBS converted the bonds into stock and investors lost about 18% even with the high interest rate.
Investors lost an average of 2% on the 180 reverse convertibles issued by RBS last year that matured by Nov. 30, Bloomberg data shows. The securities had a total face value of $69.3 million. Pholida Phengsomphone, an RBS spokeswoman, declined to comment.
"This isn't something that a retail investor calls up and asks for," said Marilyn Cohen, who oversees $250 million as chief executive of Envision Capital Management in Los Angeles. "Is it ever explained to them that you might end up with the stock, and there's a large probability that will happen?"
Buyers profited on 75% of the notes analyzed by Bloomberg. The average return was negative because investors lost more on the unprofitable ones than they gained on those that made money. Investors also took on credit risk because the notes are unsecured debt.
"There's no free lunch," Tongue said. "If you're going to get superstandard returns, that means you're taking superstandard risks."
Reverse convertibles are not traded on exchanges and their performance isn't reported publicly. Investors lost $27 million on the $2.19 billion of securities tracked by Bloomberg. Banks also sold $4.56 billion of reverse convertibles whose returns were not included because they did not mature by Nov. 30.
Kenneth Lench, head of the SEC structured-products unit that investigated Goldman Sachs Group Inc.'s investments in subprime mortgages, said in a September interview that the agency was examining whether brokers overcharged investors for the notes. He declined to comment for this article. SEC Enforcement Director Robert Khuzami said at a Senate Judiciary Committee hearing the same month it has looked at reverse convertibles.
"The reason these are popular is they're kind of an easy sale," said Charlie O'Flaherty, who formerly oversaw U.S. structured products and derivatives at Bank of Ireland. The products are marketed as a way to earn higher yields during times when stock prices are stable and interest rates are low, he said. Buyers aren't told how they have performed in the past, he said.
Most structured products are "valuable tools" that spread the fee over a longer period of time, said Richard Sandulli, a former head of structured products at Morgan Stanley and Wells Fargo who left the industry last year and is now a consultant. But paying too much commission cuts into investors' returns and encourages brokers to act against their clients' best interests, he said.
"Just because something can be sold doesn't mean it should be," Sandulli said.