Convertible Securities Offer Good Yields, Less Volatility

But some analysts complain that they are neither stocks nor bonds

QUESTION: When is a bond a stock and a stock a bond?

Answer: When it's a convertible security.

Convertible securities - both convertible bonds and preferred stock - are being rediscovered in the current economic setting of rising stock prices and confusion about the future direction of interest rates in the United States.

Convertible bonds are bonds that can be converted into fixed amounts of the issuer's common stock under certain conditions, such as when the common stock reaches a specific price. Convertible bonds pay interest but also gain appreciation in value along with the issuer's underlying common stock.

Preferred stock is a class of stock that can be converted into common stock. The preferred stock also usually pays a fixed dividend, like a bond. And it tends to rise in value along with the firm's common stock. More than $100 billion worth of convertible securities exist in the US, along with another $100 billion in convertibles outside America.

"Historically, high-grade convertible bonds [having a rating of BBB minus or above] have been able to match the returns of the [Standard & Poor's 500 index], yet with a lot less volatility" than registered stocks by themselves, says Richard Janus, managing director of convertible securities for the investment firm Society Asset Management Inc. of Cleveland. The firm manages $550 million in convertible securities.

In terms of price volatility, convertible bonds rank almost exactly in between bonds and stocks. During the period 1960-94, convertible bonds were 24 percent more volatile than the former and 25 percent less volatile than the latter, according to The Carmack Group.

In terms of return, interest plus capital gains, convertibles beat out high-grade, long-term corporate bonds over time, he says. (See box.)

Convertibles are "a total return investment," Mr. Janus says. That means an investor can receive "a good cash flow" from the bond side of the instrument while also watching the security appreciate in value as the stock of the company rises.

Some 25 of 30 blue-chip stocks listed in the Dow Jones industrial average have used convertible bonds for financing, Janus says; and more than one half of all convertible bonds sold in the US "are investment-grade bonds, not junk bonds."

"Many investors don't pay enough attention to capital appreciation, yet people are living longer than ever," says Steve Savage, editor of the Value Line Mutual Fund Survey.

Still, many investment analysts do not like convertibles. These instruments, they maintain, are a little of both worlds and not enough of either to satisfy them.

If you want to buy a stock, buy equities; if you want to buy a bond, buy a high-grade corporate bond or a Treasury bond, they say; convertibles can collapse in a down market along with stocks, as happened in the 1987 stock-market crash.

Moreover, most convertibles have call provisions. That is, the issuing party can redeem the bonds. That usually occurs when interest rates have fallen dramatically, and the issuer wants to scrap older bonds paying high rates and instead issue new bonds paying low rates.

"Most new bonds are much safer [in terms of redemption] today than in past years," Janus says.

New issues of bonds have an average maturity of 8.3 years now, he says. That compares with maturity dates of more than 20 years on bonds issued in the late 1980s.

Bond terms also often specify that they cannot be called for a certain number of years. The average time nowadays is four years, compared with two or three years in the 1980s.

Convertibles can be acquired in two basic ways: through brokers and mutual funds.

For most individuals, Janus says, it may be wise to use a broker. One reason is timing.

The best time to buy a convertible is when stock prices are rising and interest rates are expected to fall. Some analysts see that to be the case in today's market. Selecting the time can take a certain degree of savvy, but, he adds, convertibles are for anyone a little cynical about the stock or bond markets.

Mutual-fund companies offer a number of convertible products, although the funds are often quite different in regard to their objectives. The Investment Company Institute, a Washington-based trade group representing the mutual-fund industry, lists some 18 convertible securities funds. Morningstar, a Chicago-based research group, tracks some 25 convertible securities funds.

"The [convertible] funds have all done fairly well recently," says Laura Lallos, an analyst for Morningstar who follows convertibles. Among the best-performing funds, she says, are Rochester Bond Fund for Growth, Putnam Convertible Income-Growth Trust, and Fidelity Convertible Securities Fund.

Many larger families of funds issue convertible funds, including American Capital, Dean Witter, Franklin, Prudential, Value Line, and Vanguard. "The investor needs to know exactly" what kind of fund he or she would like to buy, Ms. Lallos says.

Value Line has a rating service for individual convertible issues and convertible bond funds. Many libraries subscribe to Value Line.

About these ads
Sponsored Content by LockerDome

We want to hear, did we miss an angle we should have covered? Should we come back to this topic? Or just give us a rating for this story. We want to hear from you.

Loading...

Loading...

Loading...

Save for later

Save
Cancel

Saved ( of items)

This item has been saved to read later from any device.
Access saved items through your user name at the top of the page.

View Saved Items

OK

Failed to save

You reached the limit of 20 saved items.
Please visit following link to manage you saved items.

View Saved Items

OK

Failed to save

You have already saved this item.

View Saved Items

OK