Converts -- the Best of Both Worlds? Part II

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Tuesday, we kicked off our three-part series on convertibles with a piece that introduced the hybrid security that co-mingles features of stocks and bonds. If you missed that piece, click

here. Today, we'll explain exactly how "converts" are priced and valued. Tomorrow, we'll talk about what to look for when buying a convert, and how fund investors can play too.

Though converts are equity-income hybrids, they are undoubtedly defensive. No matter how far the underlying stock falls, if the market takes a bearish turn, convert investors are still guaranteed their quarterly or semiannual coupon payment. Even if the convertible security, which often will trade on the secondary market, falls in tandem with the underlying stock, investors will still be paid their interest coupon.

"Volatility fears are making convertibles much more popular," explains Anand Iyer, managing director in

Salomon Smith Barney's

global convertible and product analysis group.

But many investors shy away because they think you need to be a math head to figure converts out. Says Iyer, "It doesn't come naturally." Yet, it's not herculean either. Let's walk through some typical converts.

A Cheap Convert

In August 1996,

Tele-Communications Inc.

(TCOMA)

sold about $1 billion worth of convertible preferred shares (although most converts are bonds that turn into common stock, some use dividend-paying preferred shares that turn into common stock). The convert preferreds, issued through TCI's Pacific subsidiary (TPACP:Nasdaq), pay a 5% dividend and are exchangeable for stock of the parent company in 2001.

Each preferred share, sold initially at $100, is exchangeable into 5.44 TCI common shares. The conversion premium was set at about 20%, when TCI was trading at around $15 per share, which would have valued TCI in the exchange at $18 per share. (15 + (15 x 20%) = 18; or more simply, 15 x 120%

the value plus the premium = 18).

But now, there's a twist. Since the time the convert was issued, TCI has surged past the conversion price and is at $29 per share. This convert is now called a "deep-in-the-money" convert; the price of the convert preferred has moved up dramatically, to $167.50.

Let's do some simplified math. You get 5.44 shares of TCI, which would be worth $157.76 now (5.44 x $29 per share) plus, another three years or so of 5% dividend payments on the original $100 price. That could put a total value of the convert at around $172.76 ($157.76 in stock + (100 x 5%) x 3 years) = $172.76), making the $167.50 asking price quite a deal.

Of course, more analytical types factor in "present time value of interest" and many other such minutiae, but regardless, this convert would seem like a good deal. And the experts agree. "For such a liquid stock, the convertible is pretty cheap," says Anne Cox, VP in convertible research at

Merrill Lynch

, which has TPACP on its recommend list of convertibles. Cox notes that investors will be getting coupon payments for three more years and TCI's common continues to swell -- it's up almost 170% in the past year. Because of the booming stock market, about 58% of all the convertibles issued are already deep-in-the-money.

A Busted Convert

On the other side of the convert spectrum, there are "busted" convertibles. A convert busts when the underlying stock falls below the issue price, which makes it far below the conversion price. One oft-cited example is the September 1995 issue of convertible bonds for

National Semiconductor

(NSM)

. The deal was originally priced with a 6.5% coupon and a 45% conversion premium when the stock was around $29.50 per share.

Under those terms, the conversion would have valued the stock at around $42.78 upon maturity of the bonds. Now however, the stock has dropped to around $23 per share, and it would need a whopping 86% climb in price even to reach the conversion level.

Worthless? Hardly. Yield-hungry investors still love these things because the prices of the convertible bonds have dropped on the secondary market to $982.50 per original $1,000 bond, increasing the available yield to 6.7%. Other busted converts sell at even steeper discounts and carry greater yields. When chasing yields, investors have to be extremely careful about the creditworthiness of the securities. Yield means nothing if it doesn't get paid.

Specially Structured Converts

Now let's take a look at another, newer breed of convertible security: the specially structured convert. Specially structured convertibles are easily identifiable by their acronymic name tags, such as DECS, PRIDES, STRYPES, LYONS, etc.

These unique converts allow the issuer to tailor its security to its particular need, such as deferring taxes, reworking a balance sheet or helping a shareholder sell his stake. Although these innovative structures currently make up only a small percentage of the convertible world compared to convertible bonds or preferred shares, their use is growing.

For example, investors can buy BOB (BOB:NYSE), a convertible STRYPES issued last month by

Ciber

(CBR)

, a Year 2000 company, to sell part of the 27% stake in the company held by Chairman Bobby Stevenson. STRYPES are Structured Yield Products Exchangeable for Stock, a trademarked convertible vehicle used by Merrill Lynch.

Under terms of this deal, investors buy STRYPES that exchange into a share of Ciber (specifically, one of the chairman's shares) in three years. The notes carry a 7.88% yield and a 30% conversion premium. That means Ciber's stock -- which was around $54 per share at the STRYPES' issue date -- will be valued around $70 in the conversion. BOB has followed the stock price of Ciber as it ticked upwards since issue. On Tuesday Ciber closed at 64 15/16, and BOB was trading at 63 5/8 (the convert is lower because investors also get the 7.88% coupon payment).

However, as often is the case with specially constructed issues, there is some fine print. Investors will get a diminishing return on a sliding scale if the stock increases greatly above the 30% premium level. These twists are one reason these particular constructs may be better left to professional money managers.

Tomorrow,

TSC

will examine how individual investors can buy converts and what to look for in a convertible mutual fund.