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The diversity and hedge capabilities of convertibles offer investors opportunities to tailor a portfolio to meet their specific goals. Many investors often brush aside convertibles, because of their complexity. Nevertheless, the basic principles and terms are as easy to understand as the key concepts of “straight” (nonconvertible) stocks and bonds, and even the more advanced concepts of convertible trading can easily be learned. Though some of the following concepts may seem complicated, a basic understanding is all that’s necessary in most cases, because our model calculates and determines many of the values for each convertible listed in our survey.

It is not uncommon for analysts to have different opinions on the price of a particular convertible, since each component of a convertible— the fixed income (or bond) portion and the warrant (on the underlying equity)— is evaluated in different ways by different analysts. The value assigned to the bond portion plus the value of the conversion feature together form the fair value for the convertible security, and that value is then used as a benchmark by our model to determine if the price of the convertible is over- or undervalued. The two main factors used in evaluating a convertible, however, are the issue’s conversion value—calculated by multiplying the effective conversion ratio by the current stock price— and its bond value. Sometimes, the conversion ratio may be a unit composed of two or more securities (in the case of a spin off) or stock plus cash (in the case of a completed merger, where the convertible is left outstanding). On the other hand, an issue’s investment value is also fairly easy to understand but more complicated to accurately derive. The investment value of a convertible is that value the issue would command had it been without the conversion feature. Thus, the conversion value and the investment value represent theoretical “floors” below which the issue should not trade.

Once an issue’s conversion value is determined, and its investment value is estimated, the premiums over both of these values become the two most important factors in determining to what degree the issue is bond- or equity-sensitive and in estimating whether the issue is over-or undervalued. The issue’s premium over conversion value is simply its current price divided by its conversion value, expressed as a percentage, and its premium over investment value is the same formula, substituting estimated investment value for conversion value. The magnitude of an issue’s premium over conversion or investment value will determine how much the issue is exposed to changes in the price of the underlying common, interest rates, or both. For example, if the issue has a low premium over conversion value but a high premium over investment value, the issue will be very equity-sensitive and have a high correlation to movements in the underlying stock, but be relatively insensitive to changes in interest rates. On the other hand, if the issue has a low premium over investment value, but a high premium over conversion value, the opposite will be true—high sensitivity to interest rates, low sensitivity to changes in the underlying common’s price. If the issue has a modest or moderate premium to both values, it will have moderate exposure to changes in both the price of the underlying stock and to interest rates. The combination of these premiums also helps to determine an issue’s upside potential versus downside risk (leverage projections). Also, the magnitude of the premiums versus the convertible’s reward/risk ratio aids in evaluating whether or not an issue is over- or undervalued.

The last two features investors should be familiar with before purchasing convertibles are the call terms and put terms (if any) of the individual issues. Call provisions are the terms under which the issuing company can redeem (buy back) the convertible from the holder. In general, the warrant value—conversion premium—of a convertible increases in value as the duration of its call protection increases. Issues that are callable, however, will trade at little or no premium if a call appears likely. The put feature is the ability to sell the convertible back to the issuing company, on a certain date, for cash, stock, notes, or a combination of two or all. If a convertible is putable, it adds another floor of downside protection, providing the market believes the company can honor the put. “Hard” puts for cash are the most valuable.

Convertible Flexibility

As most seasoned convertible investors know, investing in convertibles involves a trade-off. As opposed to buying the stock outright, full participation in a stock’s upside potential is often traded for the downside protection a convertible’s yield advantage provides. In addition, convertible investors will usually receive a lower coupon than a straight (non-convertible) bond or preferred would offer, because of the equity play holders have if the underlying common rises. Still, over time, some issues will move toward being almost pure equity plays, some toward fixed-instrument vehicles, and others will hold the characteristics of a typical convertible. This creates a uniquely attractive feature of convertibles in that portfolios can be tailored to different market conditions, strategies, and investor goals, yet still participate and be profitable if the market moves in an opposing direction. No matter which side of the market an investor wants to be in, chances are investors can utilize convertibles in hedge strategies to suit their purposes. Here are some of the choices investors have in designing a convertible portfolio:

Equity sensitivity, bond sensitivity, or a combination of both. As mentioned, an issue’s premium over conversion value and premium over investment value determines how sensitive an issue is to movements in either the underlying stock or interest rates. Investors looking for equity plays should focus on convertibles with low premiums over conversion value. Investors seeking yield plays should look for issues with low premiums over investment value. In addition, investors seeking moderate exposure to both markets should look for issues with modest premiums over both, or the portfolio could be diversified to have some sensitivity to each market by having a mix of equity-sensitive and yield-sensitive convertibles.

Industry diversification or target market sectors. As a general rule, investors should diversify their convertible holdings, if possible, across 10 different issues in at least 10 different industries. This decreases their exposure to market risk and industry specific risk. Still, for investors looking to bet on a rebound in a specific industry, convertibles offering favorable leverage (due to their higher yield, and thus their downside protection versus the common), can be found in virtually all industry segments.

Focus on convertibles that are investment quality or “junk” grade and/or play the yield curve. Again, investors who buy convertibles accept a trade-off. At issuance, buyers accept a lower yield (usually 1%- 2% below that of a “straight” bond of equivalent terms and quality) in return for the warrant component of the convertible (which provides participation in the underlying stock). Most convertibles offer higher yields than their underlying stocks and have more secure payouts than common dividends. Indeed, most convertible preferreds accrue missed dividend payments, but in the case of convertible bonds, the company will usually lose some degree of control if it defaults. Also convertibles have a higher claim on company’s assets if the company goes under. As a result, the debt component of most convertibles offers holders downside protection. But the ability of the company to honor its payments now or in the future will depend heavily on this downside protection. Bond rating agencies have a range of investment grades, which represent a company’s risk of default on a specific issue. In our service, investment grades range from A (Highest) to L (Lowest and in bankruptcy). Our investment range of D (equivalent to an S&P rating of BBB) or higher, corresponds to issues considered of investment quality (low risk of default). Below-investment-grade quality issues (E or less in our service) are technically termed “junk” bonds. As the investment grade declines, the risk of default increases. Still, companies with investment grades of E, F, and G are considered viable and should not be overlooked. The vast majority of convertibles outstanding are issued by small to mid-sized capitalization companies, and the investment grades of these issues often fall within this range). Grades of H and I, however, should be viewed carefully.

The investment grade should establish a cutoff for purchase candidates. While investment- quality issues offer greater certainty that payments will be honored, yields rise as investment grades slide. In addition, opportunities can arise in which a financially secure convertible trades on its investment value, and the warrant portion is virtually free. This can create an opportunity for investors looking for the issue’s pricing to reflect the value of the warrant component, but we caution that situations where a convertible appears to trade at or below investment value may reflect market anticipation of a reduction in investment grade—and the market is often right.

Playing the yield curve is another way to capitalize on investment grades and values. In this case, investors would focus on issues with a very high premium over conversion value that trade below their estimated investment value. Investors seek to capitalize on the issue’s price rising to its investment value. Such “busted” issues are often undervalued. This is because they are out of favor in the convertibles market and are unappreciated in the bond market, particularly in the case of junk convertibles. Another slant on this strategy is to shift investments to shorter maturities if interest rates begin to rise and then move back to longer maturities when rates appear to peak. The risk of this particular strategy, however, is if the yield curve flattens rather than moves up across all maturities. This puts more downward pressure on pricing on short-term issues than long-term issues.

The ability to hedge convertibles. Although rising interest rates and falling equity prices are usually viewed as a convertible holder’s worst nightmare, there are various ways to hedge convertibles that will keep losses at a minimum and potentially produce gains, even in adverse market conditions. These strategies include selling common short against convertibles, a strategy that offers the strongest downside protection to declines in the underlying common. Another common hedge strategy is writing call options against convertibles that can be tailored to provide varying degrees of downside protection, as well as increase income. While there is no hedge strategy to protect convertibles against a rise in interest rates, a falling bond market is usually accompanied by a declining equity market. As a result, hedging the equity side of the convertible will often cushion the decline in its investment value.

Recap

Overall, there are always plays to be made in the convertible market. For investors with a long-term view, a buy and hold strategy— riding out the short-term ups and downs— is a solid investment strategy. Still, for convertible investors who feel they can “time” market shifts and who want to hedge their positions, convertibles offer a wide variety of possibilities. In addition, for investors looking to make new investments, convertibles offer numerous possibilities for tailoring a portfolio’s sensitivity to the equity market, the bond market, or both.