Cruising for Convertibles

These stock-bond hybrids offer higher returns for savvy investors

Now may be the time for you to get in the driver’s seat with convertibles. Analysts maintain that purchasing these part stock, part bond hybrids can be a sound defensive move in today’s unpredictable market. And in an environment in which the Dow Jones Industrial Average has significantly risen and fallen on any shred of economic news, you need all the protection that you can get Convertibles are best suited, however, for the more sophisticated investor who has spent years tracking the stock and bond markets. “By buying these undervalued bonds now, the investor stands to benefit from temporary dislocations in the convertible market of the sort that come along only a couple of times each decade,” says Stephen J. Seefeld, founder of Convertbond.com, a Greenwich, Connecticut-based investment management firm.

Simply put, they provide downside protection and higher income. The reason: when you own a convertible, the issuing company grants you the right to swap your bond for shares of common stock. This feature gives you the ability to reap the benefit from the bond’s yield and, if the stock price rises, the flexibility to profit from conversion. “When the stock market falls, convertibles do not drop as much as the underlying stock,” says George Graham, editor of Value Line Convertible Strategist, a weekly publication that tracks the hybrid investment. “You can keep collecting regular income no matter what happens to the stock. But you don’t earn as much interest as you would have had you bought a [pure] bond.”

You can exchange the bond when the stock price rises to a designated figure (the conversion price), which is higher than the shares at the bond’s issuance. The price of the convertible bond depends on three factors: the interest rate, the company’s credit quality and the price of the common stock.

Graham cautions you not to pay too high a premium for a convertible. Say company A issues a convertible bond and, at the time, the stock is selling at $32 per share. The conversion price is $40, a difference of $8. Then, the conversion premium would be 25%, or $8 divided by $32 to yield 0.25.

Before pursuing these vehicles, experts offer the following tips:

  • Take a close look at the company issuing the bond. More than half of all convertibles are issued by small and mid-size companies. The bonds tend to have average or less-than-average investment grade quality. Some blue chip companies issue convertibles that have strong ratings of BB or above. You can check the ratings through such services as Standard & Poor’s or Moody’s.
  • Seefield recommends at least five companies that offer attractive convertibles: Diamond Offshore, Nabors Industries, Hilton Hotels, Parker Drilling and Systems and Computer Technology (see chart).
  • Know the call provisions. If the issuer exercises its right to redeem the bond before maturity, you may not recover your principal.
  • Realize that you may be forced to convert against your will. In the event of a hostile takeover or a similar event, the bonds may be converted into shares as a move
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