When stocks do fall, convertible bonds may be a cushion
How high is high? That's what many investors, professional and part-time, are wondering as they watch the stock market climb to new heights almost every week.
The next question is: When the answer to the first question comes and the decline begins, how do we get out of the way?
For many investors, the answer is convertible bonds. This hybrid of a stock and a bond is sometimes called the best of both worlds, and it's apparently good enough to attract millions of investor dollars and prospectuses from several mutual fund companies that have started convertible funds.
A convertible bond, like a regular bond, is a debt instrument issued by a corporation. But unlike an ordinary bond, which starts out as a bond and stays that way throughout its life, a convertible can be transformed into shares of the company's stock. Combine these two characteristics, and you get the appreciation potential of common stocks and the income potential of bonds. One result is an investment that can perform almost as well as a company's stock in a bull market - but a lot better than the same stock when the bears are loose, because, even when the price goes down, they keep paying interest.
Last year, convertible bonds averaged a 14 percent return, compared with 18.5 percent for the Standard & Poor's 500 index.
Another advantage is that convertibles are debt instruments, so in case of bankruptcy, people holding them have an earlier claim on the company's assets than stockholders do.
The companies issuing them like convertibles, too. ``When the market's up and interest rates are down, it's an opportunity for companies to issue bonds at very attractive rates,'' says Steven Anreder, director of convertible research at Drexel Burnham Lambert. The equity ``kicker'' in convertibles means investors will accept a lower yield from them than they would with ordinary bonds.
``There are times when convertibles have done better than the [stock] market,'' says Carol Sachs, senior vice-president of Noddings-Calamos & Associates, an Oak Brook, Ill., investment company. ``In any fully ripe market, you'll see convertibles do better than stocks.''
But making money in convertibles isn't simply a matter of buying some bonds, putting them away, and smugly awaiting the next big drop in the stock market. They have to be actively managed, and there should be a lot of them in the portfolio, another reason many people go with mutual funds. Ms. Sachs contends that a well-balanced portfolio of convertibles should contain at least 100 bonds. While other professionals believe adequate diversity can be obtained with a couple of dozen bonds, that's still a lot to select and follow.
The reason for such diversity is that convertible bonds have several characteristics that neither stocks nor bonds have. One is the fact that the bonds are converted to stocks in different ways, at different times, and with different premiums. Each bond has a ``conversion ratio,'' which is the number of common stock shares it can be exchanged for. There is also a ``conversion value,'' or the market value of the underlying shares. This is found by multiplying the stock's current price by the conversion ratio.
The ``conversion premium'' is the difference between the higher price of the bond and the lower value of the stock. Then there is ``call protection.'' The bonds have different dates when they can be ``called in'' or converted to stock. Knowing when this happens - and when the income from the bonds will stop - is up to the investor.
In the past, convertibles were mainly issued by smaller, emerging companies that do better at attracting investor interest in their debt than in their stock. But a couple of years ago several large companies, including International Business Machines, Bell & Howell, and Digital Equipment began putting out convertible issues.
This has helped create two convertible markets, Ms. Sachs says. One is the market of large, blue-chip convertibles where the risks are small and the returns, though slightly less than stocks, are still respectable.
The other is the market of convertibles issued by low-capitalized, small companies. While the risks here are greater - some of the companies could go bankrupt - the rewards from those that survive ``can be spectacular,'' Sachs says. For example, she recalls, convertible bonds were issued earlier this year by Varco Inc., an oil service company. With the price of oil down and, at the time, showing few signs of going up, most analysts weren't interested in a company like this. Its stock was selling for about $2.50 a share. Today, the stock is trading at about $9 and the bonds that had a face value of $1,000 are worth about $3,600.
In a more ``normal'' stock market, convertibles can do even better, says Thomas Revy of Froley, Revy Investment Company, a Los Angeles investment advisory firm. The current bull market, he says, has been different from most because it has been consistently led by blue-chip stocks, while the secondary stocks have grown more slowly. If this situation changes, convertible bonds, with their stress on smaller companies, should be expected to do even better.
But the complicated nature of convertibles still daunts many investors, which is why mutual funds have gained so much attention. Until a few years ago, most convertible funds were sold through brokers, who could explain how these complicated instruments worked. But as investors have become more sophisticated, and have demanded lower or no sales charges, the no-load groups have started offering convertible funds.
Noddings-Calamos has two no-load convertible funds. When these funds were opened two years ago, there were very few no-load funds for convertibles. Since then, several companies, including Fidelity, Stein Roe, Vanguard, and Financial Programs, have started no-load funds that either invest almost exclusively in convertibles or make them a large part of the portfolio. Another no-load convertible fund is offered by Value Line. Some convertible funds with loads, including the Putnam Convertible Bond Fund and the Phoenix Convertible Fund, have also performed well.
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