If you’re an income-hungry investor, a stagnating stock market or crumbling yields on certificates of deposit. money markets and bonds can put a big dent in your cash flow. When this happens, there’s a short-term investment idea that you might want to consider: reverse convertible notes (RCNs). These securities provide a predictable, steady income that can outpace traditional returns — even those of high-yield bonds. Read on to learn more about them, and how to add them to your portfolio.

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Reverse convertible notes are coupon-bearing investments with payouts at maturity; and, they are generally based on the performance of an underlying stock. The maturities on RCNs can range from three months to two years.

The notes are usually issued by large financial institutions. However, the companies whose stocks are linked to the RCNs have no involvement at all in the products.

RCNs consist of two parts: a debt instrument and a put option. When you buy an RCN, you are actually selling the issuer the right to deliver the underlying asset to you at some point in the future. (Find out how a put option works in How is a put option exercised? )

How Payouts Are Determined

Before maturity, RCNs pay you the stated coupon rate, usually in quarterly payments. This constant rate reflects the general volatility of the underlying stock. The greater the potential volatility in the stock’s performance, the more risk the investor takes. The higher the risk, the more you get for the put option. This translates into a higher coupon rate.

When the RCN matures, you’ll receive either 100% of your original investment back or a predetermined number of the underlying stock’s shares. This number is determined by dividing your original investment amount by the stock’s initial price.

There are two structures used to determine whether you will receive your original investment amount or the stock:

• Basic Structure — At maturity, if the stock closes at or above the initial price, you will receive 100% of your original investment amount. If the stock closes below the initial price, you’ll get the predetermined number of shares. This means you’ll end up with shares that are worth less than your original investment.
• Knock-In Structure — You’ll still receive either 100% of your initial investment or shares of the underlying stock at maturity. With this structure, though, you’ll also have some downside protection.

For example, suppose your $13,000 RCN investment includes an 80% knock-in (or barrier) level, and the underlying stock’s initial price is $65. If, during the term, the stock never closes at $52 or less, and the final price of the stock is higher than the knock-in price of $52 and you’ll get your original investment of $13,000 back.