Printer Friendly

Riding out the market in a convertible.

The 1994 stock market taught many investors the meaning of bond-market volatility. These days, "conservative bond investing" doesn't look like such a sure bet anymore. But don't let short-term developments discourage you from staying fully invested in the market. By using convertible securities, which combine the elements of bonds and stocks and exhibit certain investment characteristics of both, you can blend the advantages of fixed-income and equity instruments.

Convertible securities were first used more than 100 years ago to finance railroad construction, and the market volatility of the past 25 years has made them popular vehicles again. Many issuers, especially new companies with unseasoned securities, are adding the convertible option to preferred stocks or bonds to make them more attractive to buyers. Plus, seasoned and high-capitalization companies seeking worldwide securities distribution have begun to offer convertible bonds to foreign investors in the European bond market, a practice that will almost certainly grow as the securities markets continue to globalize.

How do convertible securities work? They can be either bonds or preferred stock, but it's easiest to understand them as bonds. A convertible bond is a regular corporate debenture with a fixed coupon and maturity date that can be converted into a fixed number of shares of common stock, at the holder's option.

THE BEST OF BOTH WORLDS

A convertible security has value both as a bond and as stock. Its bond or investment value is calculated by standard fixed-income analysis: maturity date, coupon, credit quality, company fundamentals, yield to maturity and call features. The investment value of a convertible bond remains stable over a wide range of stock prices and drops only as the stock price approaches zero, which means the company is nearing bankruptcy. In an uncertain stock market, the investment value of the convertible bond constitutes a floor value for the security. The investor can continue to hold the bond and collect the coupon interest, and he'll still be repaid at maturity.

A convertible bond is also valued in terms of its underlying equity, so it's important to remember that assessing the equity value of a convertible involves performing the same kind of credit analysis required for any stock. This means looking at the future prospects of the company, the risk measures of the common stock and how much equity participation the convertible bond represents.

At issue, the number of shares the bond can be converted into (the conversion ratio) is fixed. Multiplying the number of shares by the current value of the stock yields the conversion value of the bond. For example, if a bond can be converted into 25 shares of stock and the stock currently sells at $35 per share, the conversion value is $875. It's very unlikely the convertible's value will fall below its conversion value. If it did, investors would buy the bond and immediately convert it into stock at a profit. As the underlying stock increases in value, the convertible appreciates in value as well, and it can increase far beyond its bond value without equity conversion. This feature provides price protection for the bond in markets where interest rates are increasing.

The price track of a convertible bond refers to how it will trade over a variety of market conditions. A convertible usually commands a market price higher than either its investment value or conversion value. This conversion premium is the amount by which the market price of a convertible bond exceeds the conversion value, expressed as a percentage, and represents the value of the option to convert the bond into stock.

The final step in pricing the convertible might be the hardest: pricing the security itself and determining how much it will rise or fall under different market scenarios. The convertible can be overpriced or underpriced relative to the stock. The risk and reward characteristics of the individual security depend on where it lies on the price curve. This in turn determines the performance of the security and the portfolio to which it belongs.

When the market price of the convertible lies along the horizontal part of the price curve, it trades more like a bond. As the value of the convertible starts to increase with the underlying stock value, it trades more like the underlying equity.

The coupon on a convertible bond will be somewhat lower than that on a nonconvertible bond. However, the convertible will have about 70 percent to 80 percent of the upside potential of the underlying stock and 40 percent of the downside potential.

Adding convertibles to a stock and bond portfolio can enhance returns and reduce risks at any level. For example, a portfolio of 50 percent convertibles and 50 percent equities has about 12 percent more risk than one composed of 100 percent bonds, but the first portfolio gets about 30 percent greater return. Put another way, it has about 15 percent more return for 24 percent less risk.

DECEPTIVE SIMPLICITY

But keep in mind that convertibles might not be good investments for everyone. Their deceptive theoretical simplicity hides a highly complex evaluation process, which is necessary to derive the full benefit of using the securities. Correct evaluation takes into account elements of bond, stock and option pricing, including current interest rates, both long and short; the probability of a bond call; the convertible's yield advantage over common stock; the fixed-income value of the convertible; and the underlying stock's volatility. Only after assessing these variables can you gauge a fair-value price for the security. This shouldn't deter you from investing in convertibles altogether, but if you're not an experienced investor, you might want to seek the guidance of an investment adviser.

Since the convertible market is most often institutional in nature, the minimum market transaction is $100,000 or more. Even if you're in a position to buy individual issues, make sure you have enough diversification in your overall portfolio.

It's also best to approach the convertible market by sector, and in-depth sector analysis is again an institutional activity. The investment-grade, high-capitalization market often performs very differently from the low-capitalization sector, which can consist of securities that aren't rated or are rated below investment grade. Since the convertible market reflects what's happening in the stock and bond markets, it's better to look at these market sectors rather than at broad generalizations about the total market. You may want to consider taking advantage of convertibles through a mutual fund or managed account of some kind.

Although the convertible's market price usually reverts to its theoretical fair value over time, you'll always have market anomalies like the market conditions of 1994, where none of the market models seemed to work. In many cases, convertibles declined in value, while their underlying stocks increased. Increasing stock values should have pulled convertible values up with them, but they didn't, despite rising interest rates; this was highly unusual.

Therefore, the current undervalued convertible market is a result of a temporary liquidity squeeze and poor market sentiment. But despite the difficult year for convertibles in 1994, the interest-rate increases took an even greater toll on straight bonds. The same increases that did so much damage to bond prices last year have brought convertible yields to the 6-percent to 7-percent range, which is as good as or better than that available on money-market investments.

And the convertible security has upside potential, an advantage that no money-market instrument or even most straight bonds can't match. In the current climate of defensive investing, where controlling risk has become vitally important, there's little doubt convertibles can play an important role in your investment portfolio.

Mr. Calamos is president and chief investment officer of Calamos Asset Management, an asset-management and research firm in Naperville, Ill.
COPYRIGHT 1995 Financial Executives International
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1995, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
Printer friendly Cite/link Email Feedback
Title Annotation:Personal Financial Planning; convertible securities
Author:Calamos, John P.
Publication:Financial Executive
Date:Jul 1, 1995
Words:1280
Previous Article:Playing favorites.
Next Article:Keeping the watchdog healthy.
Topics:


Related Articles
Earnings per share for ESOP convertible preferred stock.
HEDGE FUNDS: Worth A Closer Look?
Ready for prime time: television's financial wizards premiere. (Next Month).
Profit from flexibility: convertible bond funds offer many of the pluses of stock portfolios with less risk.
id-Confirm, Inc. -- Closing of Convertible Debenture Offering.
id-Confirm, Inc. -- Second Closing of Convertible Debenture Offering.
U.S. Bancorp Announces Agreement to Sell $2.5 Billion of Convertible Senior Debentures Due 2036.
U.S. Bancorp Announces Agreement to Sell $3.0 Billion of Convertible Senior Debentures Due 2037.

Terms of use | Privacy policy | Copyright © 2018 Farlex, Inc. | Feedback | For webmasters