As investors look for pockets of stability in an uncertain market, more investors may do well to become converts to convertible-bond funds.
Convertible bonds, which offer some of the upside of stocks together with some of the stability of bonds, have become increasingly popular vehicles for raising capital by corporations, giving funds that specialize in them more and more investment choices. For the year to date through May, companies issued $49.5 billion in 93 convertible-bond deals, handily outpacing the $61.6 billion in convertibles issued in all of 2000 and the $39 billion that was issued in 1999.
Some of the most recent high-profile deals include telecom giant
, which issued $3 billion in convertible bonds in April, and financial powerhouse
, which issued $2.5 billion in convertible bonds last month.
recently issued $6 billion through two convertible-bond deals.
Over the long term, the performance of convertible-bond funds has been solidly between that of equity funds and bond funds. For the five years through 2000, convertible-bond funds averaged a 14.2% return, lower than the 21.0% return for domestic equity funds but much higher than the 5.0% for all other types of bond funds, according to
. Year to date through May 31, convertible-bond funds are down 2.9%, while domestic equity funds are down 5.0% and bond funds are down 1.0%, but analysts still see convertibles as a solid play.
"Over the past year, as the stock market has tanked, a lot of convertibles have held up better than stocks, while delivering better returns than bonds," says William Harding, an analyst at Morningstar. "So investors who are a little scared about what's going on in the market can include these in the mix."
Says Lew Altfest, president of New York financial advisory firm
, "In a slower market, yields count for more, and the convertible-bond funds provide yields plus capital gains."
Twenty-six mutual funds with $8.3 billion in assets under management now specialize in convertibles, according to Morningstar.
Why Convertibles Now?
A growing number of companies are interested in raising money through convertibles because these bonds are a less expensive form of corporate debt than junk bonds. Companies can issue convertible bonds with lower yields than traditional bonds because they have the added feature of being convertible into stock shares once a pre-set stock price is reached. Individual investors are finding that, of late, some of these investments have performed better than stocks.
Jeff Seidel, director of global convertible research at
Credit Suisse First Boston
, says the growth in the convertible-bond market is making it easier for fund managers to diversify. A much broader spectrum of companies are now issuing these bonds, including communications, cyclical, energy, finance, consumer staples, health care, utilities and technology companies. And about half of the companies issuing convertible bonds are investment-grade compared with younger companies with lower credit ratings that dominated the convertible-bond issues until last year, Seidel says.
Because these securities are like stocks, the expense ratio of the 26 convertible-bond funds are about equal to equity funds. The average fee for a convertible-bond fund is 1.49%, according to Morningstar, while equity funds charge 1.42%. Bond funds have a much-lower expense ratio of 1.10%, on average.
The Ways of Convertibles
Convertible bonds pay investors interest-rate yields just like any other bond. But they are typically lower than other types of bonds because the security can be converted into equity if the stock of the company reaches a certain premium. The so-called premium conversion price is typically 20% to 40% above a stock's value at the time the deal is underwritten.
Investors give up about two percentage points on the yield side. Harding says investors should expect convertible bonds to pay about 4% to 5% currently, compared with the 6% to 7% corporate-bond yield.
When a company's stock is rising, investors can't gain as much on the upside as someone who holds only stock. But they'll be buffered on the downside. "The price of the convertible bond will give 60% to 80% of the upside of a stock and 40% to 60% of the downside," Harding says.
Take, as an example, a $1,000 convertible bond with a 5% yield where the stock was originally trading at $80 and the premium conversion rate was set at $100. If the stock rises to $120 and an investor decides to convert the bond to stock, he'll get 10 shares worth $1,200 -- a 20% return. The equity investor, on the other hand, will get a 50% return.
On the downside, a convertible bond will never fall as much as the stock because its guaranteed yield will bolster its value. Take the same $1,000 convertible bond. If the stock tanked to $20, the convertible bond would theoretically be worth $200. But the bond is still yielding 5%, or $50 annually, on the original $1,000 bond. On a current value of $200, the yield would be 25%. Because this is a princely yield, the market would bid the convertible bond's value back up, possibly to the $500 range. The stock investor would have seen his original $80 investment decline 75% to $20, but the convertible-bond investor would be hit with a 50% decline.
"On the upside, it is driven by the stock value. On the downside, it is driven by the yield," says
senior analyst Donald Cassidy.
Aside from giving up the chance to earn greater returns, there are other risks. "Not only do you have to do the research on the underlying stock," Harding says, "but also on the issuer's credit rating and the pricing structure of the loan. Each convertible comes out with a different type of structure, and you have to understand that."
There's also the risk the company will default on the debt. And while the convertible-bond market has been growing -- and even growth and income fund managers have been investing small amounts of their portfolio in convertibles -- convertibles are still a small and fairly illiquid market, which is why mutual funds are probably the best way for most individual investors to get exposure to convertibles.
But with the markets volatile and many stocks disappointing, investors can expect convertible bonds to get more attention.