Taking a Ride With Convertibles

In the last week, I've had a tough time hearing anything over the din of TSC readers clamoring for more specs on convertibles. I heard you call loud and clear and decided to run an entire piece on the subject -- dedicated to the intellectual masses in search of investment truth.

A warning for all of you auto buffs: We're not talking convertibles as in your dad's '64 Chevy Chevelle; we're talking convertibles as in bonds and preferred stock -- those hybrid securities devilishly pieced together in the back-office laboratories of investment banks and sparked to life to roam Wall Street and reign mass confusion down upon individual investors.

Knowing the Basics

As I've touched upon briefly in a past article, convertibles are like the half-breed offspring born of the unlikely union between stocks and bonds. Due to their twisted genetic heritage, these Wall Street doppelgangers can exhibit characteristics of both debt and equity at various times during their life, depending on market conditions.

In short, a convertible is a debt instrument (either a bond or preferred stock) with an attached feature that allows the holder to convert the security into common stock at some point in the future. The idea is that the debt portion produces a predictable stream of spendable income while the conversion feature gives the owner some upside potential if the stock goes bananas.

Sounds like the best of all worlds, right? In a bad market, you get the safety of a bond with a fixed interest payment. In a good market, you get to cruise the strip and cash in on the stock price run-up. Well, not quite.

As with all investments, convertibles involve certain trade-offs. Understanding those costs and benefits can help you take the mystery out of the asset so you can capitalize on available opportunities. In order to understand convertibles, it's helpful to disassemble them by their component parts and get a closer look at what makes them tick.

Kicking the Tires

Since convertibles are, beneath their shiny paint job, fixed income vehicles at heart, they share the same plain vanilla looks as the rest of the asset class, including coupon payments (or dividends in the case of preferreds), credit ratings, and often a maturity date and call feature. So when you're out shopping, these are the first things to check out.

Take as an example Amazon.com's (AMZN Quote) recently issued 10-year convertible notes with a 4 3/4% coupon and single-B S&P rating. (I doubt you'll see many trading outside of institutional circles, but it makes a simple and timely illustration of the basic concepts.)

Presumably, the worst you'll ever do with the security is receive $47.50 every year for each bond you own (4.75% times the face value of $1,000) and get your principle of $1,000 back in 2009. Of course it's anyone's guess exactly how a company with negative cash flows projected until '01 is expecting to make those payments without adding a counterfeiting division, but that's why they've got the single-B, or junk, rating. (And it sure didn't deter $1.25 billion of institutional dollars from gobbling up the entire issue last month like gamblers at a Vegas buffet.)

Popping the Hood

Now you're probably thinking, "Hey, I can get 4 3/4% in a money market fund without all that risk," and you're right. But before you walk away disgusted, take a closer look at the options package. Beneath their mom-and-pop appearance, the Amazon 4 3/4s of '09 contain a conversion feature under the hood that can give those stodgy bonds a real power boost during a hot market.

In Amazon's case, the supercharger takes the form of a conversion feature that allows each creditor to trade in their certificates for 6.41 shares of AMZN common stock at any time prior to maturity. The conversion ratio itself is set by management before the issue, presumably with guidance from a well-paid team of investment bankers and their Magic 8 Ball. Ultimately, the conversion ratio is a big determinant of the security's value in the marketplace.

One way to use the ratio is to ask yourself what price the stock needs to be trading at in order to make money on the conversion. To get the answer, simply take your purchase price of the convertible bond and divide it by the conversion ratio. In the Amazon example, assuming you picked up the bond at par ($1,000 per) your "market conversion price" will be $156. In other words, AMZN needs to be trading above 156 for you to have any incentive to convert the bond to common.

Conversely, you might want to know how much the bond would be worth if you converted it immediately into stock today (a figure known as the "conversion" or "parity" value). To get the figure, just take the market price of the stock and multiply it by the conversion ratio. For AMZN you're looking at, $101 (stock price) * 6.41 (conversion ratio) = $647 -- well below the par value of $1,000. In a nutshell, the minimum value of a convertible will be either (a) its "conversion" or "parity" value, or (b) the value of the bond itself with no conversion feature factored in.

What this tells you is that when the stock price is well above the conversion price, the convertible trades like a stock, matching price moves in the underlying equity practically one for one. However, if the stock falls way below the conversion price, the convertible trades just like a straight bond, effectively putting a price floor under your investment.

Sounds great, right? Seemingly unlimited upside with limited downside. Not so fast. A convertible is a lot like a standard bond with a call option attached to it, and that option costs extra, usually in the form of lower interest payments on the bond portion of the security.

Thinking About the Road

Nevertheless, out on the highway, convertibles generally function as promised, giving sunny returns during good weather and offering some protection from the rain during the inevitable storm.

Those upside returns, however, usually lag the market due to the drag from the implied conversion premium. In addition, the floor is more like foam rubber than concrete and can vary due to changing interest rates and credit ratings.

Closing the Deal

Convertibles still tend to be a relatively scarce item on the market, so assembling a diversified portfolio on your own could pose a big challenge. Several mutual funds, however, specialize in converts (pronounced con-VERTS, not CON-verts) and may be worth taking a look at. A quick tour through Morningstar.net's fund screener yields a few dozen funds that might fit the bill, including offerings from Fidelity, Putnam and Oppenheimer.

Most of the pure plays, however, have underperformed the raging bull market over the last couple of years, for reasons described above, and as a result have relatively low Morningstar rankings. A typical example is Franklin's two-star Convertible Securities fund that's been lagging the market by 14% over the last 5 years.

The trade-off is limited downside risk. Along with their lackluster 9% average returns, the fund also has a beta of just 0.55 and ranks 2 on a scale of 10 in bear-market performance.

So if you think the markets are starting to look top heavy, convertibles may be just the ticket. Just don't expect to break any speed barriers on the open road if current bull market conditions persist.

As always, keep those questions coming. We'll see you here next week.