_{If You’re Considering Convertibles}

Are you tired of stock market gyrations, but not yet ready to abandon equities for bonds and cash? Then you might want to consider convertibles. These investment hybrids have some of the appreciation potential of common stocks, but they also provide income from the coupons or interest rates they earn.

Convertibles are Wall Street’s version of the reversible raincoat—they have some of the characteristics of common stock, then when you “flip them over” they have some of the characteristics of bonds. (There are also convertible preferred stocks, however, this article focuses on bonds.)

Convertibles are bonds that can be converted or exchanged for a specified number of shares of the issuing company’s common stock at a specified price. Should the price of the common stock fall, the price of the convertible will fall too, but it is supported by the bond’s income. Most investors may buy convertibles for their appreciation potential since convertibles come with lower coupons than regular bonds. The conversion feature compensates investors for a lower interest rate.

Who issues these quasi-bonds?

Companies whose credit ratings are lower than investment grade and those who anticipate a strong stock price. A rising stock price benefits the issuing company, since it can force conversion into stock when the share price rises above the conversion price and, thus, eliminate some debt from the balance sheet. The convertible feature allows these companies to raise capital at rates that are lower than ordinary bonds. But, be aware that a lower credit rating, usually a low B or CCC, carries more risk than a “plain vanilla” corporate bond.

Doing the Math

Convertibles require an investor to master a few calculations to properly analyze them. In additions to calculating the current yield paid by the bond (the coupon divided by the bond’s price), an investor needs to know the issue’s conversion value and its conversion premium. As an example, each $1,000 bond of the XYZ Corporation is convertible to a specified number of shares, say 15, at an exercise price of $80 per share. Naturally, the bonds are issued when the share price is much lower than $80. When the price rises to $80 or above, the investor is entitled to convert a single bond into 15 shares.

The current conversion value is $885. This is determined by multiplying the current price of the company’s shares, for example $59, by the number of convertible shares ($59 x 15 = $885). The conversion value changes with the rise and fall of the underlying share price. The conversion premium is the difference between the current price of a bond and the conversion value of the converted shares and can be expressed as either a dollar amount or a percentage of the conversion value. In XYZ’s case, the conversion premium is $115 or 13% ($1,000 - $885/$885).

The conversion shows the percentage increase necessary to reach parity between the underlying stock and the convertible bond. Bonds with lower conversion ratios are better investments because the appreciation in the common stock required for parity is smaller. Thus, it is likely that the investor will be able to convert the bond into stock sooner.

Background Check

The conversion premium is not the only criteria investors need to apply when analyzing a convertible. First and foremost, you should want to own the underlying stock. If the stock price rises and conversion is forced, you can always sell the shares. However, this may involve extra commissions, which can decrease your total return.

Analyze the company first, and decide if its common stock would be a good addition to your portfolio. Be aware of the bond’s credit rating. If you are not in a position to absorb the risk of owning a lower-rated bond, convertibles may not be for you. Consider the bond’s call protection or the number of years before it can be redeemed by the issuing company. Most convertibles have a three-year call protection. After that period, the company can redeem them at a specified price, for instance, a premium such as $1,040 or $1,020.

If the bond’s conversion value exceeds the call price, the company will exercise its call option, thereby forcing conversion. An investor usually has a 30-day window in which he or she can decide if he or she wants the stock or the cash value of the call price.

Investors should also consider the downside potential in case the conversion feature proves to be valueless. In this case, the investor must rely on the income from the coupon for his or her return. Finally, be prepared to hold the bond until conversion. While there are many new convertible issues coming to market, there isn’t a large secondary market for them.

For those investors who do not want to own the individual bonds, there are a number of convertible funds. These usually own convertible bonds and convertible preferred stock, as well as common stock. Some convertible funds concentrate more on income and others on capital appreciation. Since one reason for owning convertibles is their potential appreciation, look for the funds that focus on this aspect of the total return.

Risk Factors

Investors should remember that convertible bonds carry specific risks. Among them are: 1) market risk—should the price of the underlying common stock fall, the value of the bond may likewise fall; 2) interest rate risk—should interest rates rise, the value of the bond may fall, and 3) call option risk—should the issuing company exercise the bond call provision, the investor may be forced to decide whether it is best to convert to stock or take cash, and the timing may be inappropriate for either decision. 

The team at Luna Capital Management is continually seeking convertible securities which an attractive risk and return profile. Many of our client portfolios own income producing convertibles securities which can generate cash dividend income during flat or declining markets. Please contact us for a 30-minute complimentary portfolio review.

Full Disclosure: Nothing on this site should be considered advice, research or an invitation to buy any securities.