Convertible bonds are a bit racier but relatively safe
Stocks and bonds are, at best, highly uncertain investments. Stocks may move up while bonds drop; or they may climb or fall in lock step. One great advantage of stocks, of course, is the potential they have for capital gains. Bonds are safe and provide steady income. But a turn in the market can stymie stock gains, and the resale price of bonds can suffer if interest rates change.
One way to have the best of both worlds is to put the top down on something called convertibles and take a look inside this hybrid, though specialized, investment.
For those who don't want to learn the complicated mechanics of convertibles, a few mutual funds are available to do the selecting and monitoring for them.
Convertibles are a cross between stocks and bonds, providing the appreciation potential of common stocks and the income prospect of bonds. Although they have been available for many years, they are getting new interest lately, both from investors and issuing companies.
``At this point, we're kind of at the doldrum level of the market,'' says Gerald Guild, manager of fixed-income investments at Advest, a brokerage based in Hartford, Conn. ``So people are looking for a little different vehicle. This gives you the downside protection of a bond with the upside potential of stocks.''
There are two types of convertibles -- convertible bonds and convertible preferred stocks. The bond is usually sold at a $1,000 face value, with a fixed maturity date and coupon rate. It may be exchanged -- or converted -- for a specific number of shares of the company's stock whenever the investor wishes.
Convertible preferred stock, on the other hand, pays dividends, not interest. But it can also be converted into a predetermined number of shares of common stock.
One advantage of convertibles is that their price generally rises with the company's stock. But when that stock falls, the convertible's overall value does not decline as much, because it continues to pay interest. This continual yield gives the investor the rewards of equity without the same degree of risk.
``The yield is much better with a convertible than with a common stock,'' says Mark Tavel, executive vice-president of Value Line's new no-load convertible fund. ``The yield serves as a floor under the price level.''
Also, convertible bonds are debt instruments, so in case of bankruptcy, people holding these instruments have senior status ahead of stockholders and would be more likely to get some of their principal back. But you should not look for convertibles as a way to turn a profit from a troubled company.
``Never buy a convertible from a company unless you'd be willing to buy stock in that company,'' Mr. Guild cautions.
On the other hand, ``no one should ever buy a common stock without first looking to see if there are undervalued convertibles available,'' says Robert W. Chernow, a senior account executive in the Milwaukee office of Smith Barney, Harris Upham & Co.
While convertibles have been largely confined to smaller, emerging companies that find more investor interest in their debt than in their stock, several larger corporations have noticed the advantages of convertibles. A few months ago, IBM put out a $1.25 million issue. Other big companies in the market include Digital, Bell & Howell, United Telecom, and Johnson Controls.
It's not all pluses in the convertible business, though. The assurance of safety here is not quite as great as it would be with a straight bond. Also, the yield will usually be lower, although this is often offset by the potential for price increase.
But the biggest drawback to owning convertibles is the need to monitor them constantly or pay a broker's commission to have it done for you. Knowing the best time to buy convertibles requires an understanding of the corporate bond market, a knowledge of the companies that issue convertibles, and familiarity with terms like ``conversion ratio'' and ``conversion premium.'' These help tell the best time to buy convertibles and the best time to sell or convert them to stock.
Then there is the need to keep track of several convertibles at once. Whether the investment is common stock, bonds, or convertibles, Guild says, there should be at least five of them. Following five convertibles takes more time and expertise, so if you are going to buy them on your own, find a broker or firm that has experience in bonds, particularly convertibles.
If you don't want to worry about keeping close tabs on your convertibles or wonder if a broker is doing a good job, a mutual fund with all or part of its portfolio parked in convertibles may be for you. Until this year, all the funds that invested in convertibles were ``load'' funds, taking about 8.5 percent off the initial investment as a sales fee. But recently, a few no-load funds have emerged, with no sales or redemption charge.
``I believe firmly that load funds are sold and no-load funds are bought,'' says Carol Sachs, senior vice-president of Noddings-Calamos Convertible Funds. The Oak Brook, Ill., fund was started by Noddings-Calamos & Associates, an investment advisory firm that continues to specialize in individual convertible securities.
Because of the time and knowledge needed to explain convertibles, Ms. Sachs explained, funds could justify the sales charge. But as investors have learned more about mutual funds and convertibles in particular, less explanation is needed. Still, even with the fee, several funds have provided good returns for their investors. These include American Capital Harbor of Houston, Phoenix Convertible Fund of Hartford, and Putnam Convertible Income-Growth Trust of Boston.
Noddings-Calamos's two no-load funds (growth and income) started selling last summer and have a combined $4.1 million under management. These funds joined Value Line's no-load fund, introduced last spring, now with more than $20 million in assets, Mr. Tavel says.
If you're interested in convertibles but don't want to worry about constant upkeep, a well-run fund can provide current income and good appreciation potential with moderate risk. Convertibles have, for instance, been used by people who are willing to put a small part of their retirement savings in a somewhat riskier investment.
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