CONVERTIBLE SECURITIES: INVESTING FOR THE WARY

The sale of convertibles had a banner year in 2001, and we aren’t talking about car sales.

Convertibles are hybrid securities—either interest-paying bonds or preferred (nonvoting) stock—that can be swapped for common shares of the issuing company’s stock at a predetermined price. As you might guess, convertibles appeal to investors looking to participate in the stock market, but who like their participation more on the tame side. While not all financial planners are enthusiastic about convertibles, many like their diversification value because they are not strongly correlated to stocks, and they recommend a five to ten percent portfolio allocation.

Because selecting good convertibles is tricky, and issues available to individual investors are limited, many investors may find it better to invest through mutual funds. Whichever way you invest, it’s important to understand some basics about how convertibles work, including their risks, and what makes them potentially attractive.

A convertible bond pays out a fixed coupon rate, typically semi-annually, and has a fixed maturity. The yield is usually higher than the company’s common stock dividend, but lower than the company’s nonconvertible bonds. The preferred stock version usually pays out quarterly a higher fixed dividend, with no maturity. Both can be converted to a predetermined number of shares of common stock. The bond version normally is considered safer than its preferred version because bondholders have priority over stockholders should the company go bankrupt.

With each version, you can either sell the convertible or convert to the company’s common stock and then sell the shares. The ability to convert is, of course, what makes convertibles attractive. If bond prices fall or the stock price shoots up, it can pay off to convert; if the stock tumbles, the interest-paying feature of the convertible tends to blunt the drop. The biggest risk is if interest rates rise (thus lowering bond prices) at the same time stock prices are dropping. Then convertibles suffer a double whammy.

The decision to convert depends on a characteristic of convertibles known as its “conversion premium.” When you buy a convertible, you buy it at a price above the par value of the bond. Say you buy a convertible at $1,100 a share. You also need to know the conversion ratio, which is how many shares you can exchange the convertible for at the time you buy the convertible. Multiply the conversion ratio times the price of the stock. Say that result is $900—that is, you can convert the convertible bond into $900 worth of stock. The difference between the convertible price ($1,100) and the $900 in stock is the conversion premium—in this example, 22 percent.

Conversion premiums commonly run at 20 to 35 percent, though they can go much higher. The lower the premium, the more likely the convertible will track the stock value up and down. Higher premium convertibles act more like bonds and make it less likely the stock’s value will climb high enough to make it worth converting. The extra yield on the convertible is what eventually should make up for the premium.

On a risk/reward basis, proponents argue that convertibles can share in roughly 60 to 75 percent of a stock’s upside, but with only 30 to 50 percent of the downside risk. For example, in November 2002, the Morgan Stanley U.S. 225 Convertible Index was down about 10 percent, while the underlying equities were down 30 percent. Critics argue, however, that overall the risk/reward ratio is actually much closer, so you are no better off than if you simply bought regular bonds and stocks.

One of the risks of convertibles is that new companies and high techs are more apt to issue convertibles than blue chippers, so they can be pretty volatile. Another risk is that many convertibles are issued based on bonds rated below investment grade.

Investors also need to be wary of call features. Issues usually can’t call sooner than three years, but there is the risk that if you pay a high premium you won’t have time to make it up through interest or dividend payments before a call.

As is apparent, convertibles are a complicated security. If you’re interested, discuss them with your financial advisor.

January 2002— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by  McGuire & Co., LLP, a local member in good standing of the FPA.