Cool Convertibles for the Racy Tech Crowd

If it's not broke, don't fix it. But if it is indeed busted, invest in it.

At least that's what some Wall Streeters are saying about convertible bonds issued by tech companies with hurting stock prices.

Rather than buying shares in tumbling tech companies -- the likes of Aether Systems (AETH), ONI Systems (ONIS), Juniper Networks (JNPR) and Ciena (CIEN) -- investors might consider buying what are commonly known as "busted" convertibles. These are bonds that are exchangeable for common stock, but trading at a price that makes the conversion to stock a long shot for the bondholder.

These investments can be risky, and they are neither as liquid nor as hassle-free to buy as stocks. But these busted converts, say their fans, can be slower to fall than the underlying stock, offer a healthy return despite the unattractive conversion and hold out the possibility of a bigger upside under certain circumstances than a conventional bond. If you're worried about where these stocks are trading -- all of them are up sharply from their late September lows -- the convertible bonds, with their promise of interest income in addition to possible capital appreciation, could be the trick.

Breakdown, Shakedown

Take a look, for example, at the Aether convertibles with a 6% coupon maturing in March 2005. Last Friday, they were trading at $607.50 per $1,000 bond. That wasn't much of a bargain if you're hoping to convert that bond into stock; according to the terms of the bond, it would be convertible into about 4.1 shares of stock worth, oh, $32.38. That means the convert, at $607.50, was trading at a premium of 1,776% to parity of $32.38. A convert is generally considered busted if it's trading at a premium of 75% or higher, so that convert is, like, soooo busted.

That isn't good news for the people who bought the bonds when issued in year 2000. But for more recent buyers, busted converts have their strengths.

One, they're relatively defensive. On June 12, when UBS Warburg research analyst Catharina Kusuma put Aether on her top-10 convertible list, the stock traded at $11 and the convert traded at $610. Five months later, the stock was at $7.90 -- down 28% -- but the convert was down only 0.4%.

Top Down? Some busted convertibles
Convertible Issue	Price*	Yield to Maturity	Parity**	Bond Premium to Parity
Aether Systems 6% due 2005	$607.50	23.7%	$32.38	1,776%
Ciena 3.75% due 2008	651.48	11.8	187.21	248
Juniper Networks 4.75% due 2007	741.03	11.4	151.87	388
ONI Systems 5% due 2005	733.75	14.1	103.78	607
*Per $1,000 face value. **Total value of shares into which each bond could be converted, given current stock price. Source: UBS Warburg, TheStreet.com

Two, there's the return. Taking into account the principal and coupons, Aether's convertibles have a yield to maturity of 23.68% -- paid in cash, that is, in contrast to some preferred stocks that pay dividends in the form of additional securities. That cash yield is worth taking a look at, says Ethan McAfee, investment analyst with the Capital Crossover Partners hedge fund. "What stocks do you think you can own with returns of 23% a year for the next five years?" he asks. "I'm very hard-pressed to come up with any stocks."

You're Busted

Obviously, there are risks. Like stocks, bonds can go to zero, and some busted converts collapse completely. For example, holders of convertibles issued by Excite@Home (ATHMQ) and Exodus Communications -- both of which declared bankruptcy this year -- can kiss their yields to maturity goodbye.

But Kusuma points out that the convertible risk is a different risk than what equity investors usually focus on. Rather than worrying about revenues and earnings, investors in these securities have to focus on cash: How much a company has to pay off the bond, and how much it's burning elsewhere. "It almost doesn't matter if you miss revenue growth targets or EPS," she says, "as long as your cash burn is within budget."

McAfee says Aether's risk is reasonable. As of Sept. 30, the company had $594 million in cash, restricted cash and short-term investments on its balance sheet; the convertibles have a face value of about $300 million. That gives Aether more than $290 million to burn through before repayment problems begin to loom. In any case, McAfee says he thinks that even though Aether's business model is in question, he's hopeful the company will turn cash flow break-even before it runs out of money. In contrast, he says, his firm has avoided Akamai (AKAM) converts because the cash risk looked more worrisome.

Kusuma points out a different type of cash risk for Aether's convertibles -- the risk that the company will spend cash on an acquisition. "If they acquire a competitor for $250 million in cash tomorrow, we are in a different situation," she says.

So what makes a busted convert better than nonconvertible debt? In the theoretical case where all other things are equal, says Kusuma, the convertible has the advantage of the free call option. Should the underlying stock soar and the convert mend itself, there's the possibility -- admittedly extremely vague in Aether's case -- that the bond will be convertible into stock at a discount.

For individual investors, investing in convertibles is problematic because they trade in a market that's neither as transparent nor as liquid as the point-and-click equity trading market. For example, buying the Aether convert through Schwab requires that someone at the firm makes a phone call to find out the price, then gets back to you, the investor. Small fry are likely to pay a higher price than institutions.

With that in mind, one anonymous hedge fund manager with experience in busted converts advises extreme caution. "Unless you are pretty comfortable on balance sheet analysis," says the buy-sider, "I would say don't mess around."

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