Although less obscure than other investments available, convertible securities are a unique product. They are, in practice, a hybrid between a stock and a bond. Although hybrid nature provides investors with material benefits, it also makes convertibles more complex than either a stock or a bond alone. Below are some commonly asked questions that should help new investors better understand convertibles.
Q: The price of a bond was quoted at 93.375 and I thought that meant $93.375. However, when I tried to buy the convertible my broker says its $933.75.
Bonds trade on a percentage of par (usually $1,000). Therefore, a bond quote of 93.375 represents 93.375% of $1,000 or $933.75. Although the thought of percentage conversions may seem intimidating to some, in bond trading it is very simple. To convert a quoted amount to a dollar amount simply move the quote's decimal point one place to the right. For example: a bond quoted at 87.5 translates to $875.00. The same principle also applies to adjusting a bond's conversion value and investment value.
Q: I don’t understand the naming of convertibles. Sometimes, the name has two components?
Convertible bonds are easily identified by the issuer's name. In our publication, the issuer’s name is followed by the coupon size, a small “s” and the year in which the convertible matures. If the convertible is exchangeable into a different company other than the one that issued it, we first list the underlying common stock into which the issue is convertible, then that is followed by the name of the issuer in parenthesis followed by the coupon, a small “s”, and then the year of maturity. For example: the ArvinMeritor 4s2027 identifies the issuer as Allied Waste Industry, the coupon as 4%, or $40.00 per annum, the “s” is a break point that also helps to identify it as a convertible bond, and 2027 is the year in which the convertible matures. Convertible preferred shares are identified by the issuer’s name followed by the dollar amount of the dividend. An example is the United Rental $3.25. Note that preferred dividends are stated in dollar amount. There is no mathematics here. The Helix Energy (Cal Drive) 3.25s2025 is an example in which the original issuer was Cal Drive, but the issue now converts into common shares of Helix Energy (HLX) as a result of a takeover of Cal Drive by Helix Energy.
Q: Why don't you recommend initial public offerings of convertibles?
Initial public offerings (IPOs) of convertibles, like IPOs of common stocks, are mostly an institutional play, and it is very difficult for individuals to get in on an offering, especially if he/she has just a small account. Underwriters of an issue are usually looking for large orders to subscribe to deals of at least $250,000 and up. In recent years, most all new convertible issues are sold under SEC Rule 144A and, as such, only institutional investors (like Pension Funds) and fund managers in control of more than $100 million in net asset value are allowed to purchase them. As a result, an individual investor will usually need to have a large account with a major brokerage house and a willingness to place a large order on a convertible IPO to subscribe to a new deal.
The new issue market can be risky; initial price talk can change when the issue is sold, and individual investors have to be careful of being offered high-risk, low-quality issues that institutions usually avoid. These issues generally tend to have very low liquidity in the aftermarket. On the other hand, hot issues are often oversubscribed, and it not unusual for institutions to receive only a fraction of the amount they ordered. Overall, for the average investor there are lots of opportunities in the universe of convertibles that trade in the aftermarket so as to make playing the convertible IPO market unnecessary.
Q: How much capital do I need to invest in convertibles. I tried to place an order and my broker told me the minimum trade available was $100,000.
Like most investment vehicles, the dollar amount necessary to begin a convertible portfolio is arbitrary. However, the question focuses on two issues: Liquidity and Diversification.
Liquidity, how easy it is to buy or sell an issue, plays an important role in the availability of issues to be purchased in small lots and in determining bid-ask spreads. Issues with a total face value or liquidation size of $300 million, or more, tend to be the most liquid, usually can be easily purchased in small lots, and often have narrow bid-ask spreads. Since bonds primarily trade in a dealer market, whether or not a bond is listed on an exchange will normally have little bearing on the spread range if the issue is liquid. As a convertible's liquidity decreases, though, the range between bid and asked spreads will usually widen. Still, the size of a transaction can at times influence spreads, because lots of $50,000, or more, in face value or liquidation value are more easily traded with institutions and may have narrower spreads, whereas small orders in the $10,000 range may be hard to place and will command larger spreads. Liquidity grades for buy candidates can be found in our table of Especially Recommended issues with 1 being the Highest and 6 the Lowest. In addition, persistence is often the key to trading convertibles in small lots. Orders that cannot be filled in lots of five bonds today may be easily filled within the next few days. Still, when executing small lot trades, be aware of the execution and that the price seems reasonable in relation to the common. Sometimes, sellers and buyers of small orders will offer unfavorable terms (a couple of points higher or lower than the current market) to execute the trade and catch investors who place market orders off guard. Many subscribers have been successful in purchasing convertible bonds in lots of five or 10, and this size range should be viewed as the minimum order required to both execute trades and receive favorable commission costs. Although some subscribers have been successful in executing trades in lots of two or three bonds, it is also common for purchase attempts at small sizes like these to be unsuccessful.
Diversification, not putting all your eggs in one basket, can reduce risk and can be done in different ways to meet individual investor needs. In general, we recommend that investors have positions in 10 or more different convertible issues and, if possible, in different industries, in order to decrease company- and industry-specific risk. For example, the downgrading of a company's financial strength and, therefore, its investment grade will affect the investment value of a convertible, whereas weakness in a specific company stock or an industry group as a whole will decrease an issue's conversion value. Both situations will put downward pricing pressure on a convertible. With diversification, the risk of all issues in one's portfolio decreases and, therefore, the overall portfolio risk is reduced. However, if you are also invested in common stocks and/or "straight" (non-convertible) bonds, the need to diversify convertibles in your portfolio is reduced, because the other securities help to diversify your portfolio’s overall risk; hence, in such a portfolio, it may not be necessary to hold 10 different convertibles.
In terms of the capital required to start a convertible portfolio, we recommend investors have at least $25,000, which should be able to be diversified over five issues ($5,000 face value in each) with a little patience. Still, for investors willing to take the inherent risk of investing in only a couple of issues, or who want to add convertibles to a stock or bond portfolio, convertible positions can be established, in very liquid issues, with only a few thousand dollars. (Investors with limited capital, however, may wish to consider investing in a convertible fund to decrease the risk of investing in only one or two issues.)