Convertibles as an Asset Class
As widely expected, the economy remains in turmoil. Major indexes continue their downward trend; the housing market remains in a slump; bank losses continue to mount, despite the bailout package; and the credit squeeze has put a damper on consumer spending. Meanwhile, the global recession is adding its two cents to economic instability. In the first month of 2009, the Dow Jones Industrial Average fell almost 9%; the broader-based S&P 500 Index dropped 8%; and the NASDAQ Composite was down just over 6%. Evidently, there is no easy answer as to how to get the flagging economy on track again, even with the TARP from the government bailout package, and the new stimulus plan under Senatorial consideration which, we hope, will be approved in its basic form sooner rather than later. These factors certainly place many doubts in investors’ minds as to when we will see signs of an economic recovery. Indeed, investors are trying to establish some solid ground on which to base their decisions, but a rise in the equity markets today is only followed by a drop the next day; hardly a foundation to sustain a recovery. Any signs of a rebound may not be evident until the second half of this year or early 2010.
In the meantime, investors, searching for safer havens, are pulling out of stocks and investing in bonds and government securities. Indeed, the Dow Jones Bond Average gained 0.8% in January, while our All Convertibles Total Return Index grew 1.8%. Even the government is considering the option of buying “convertible securities from financial institutions,” with bailout money (according to an article in the January 21st Wall Street Journal). Because of their hybrid nature, convertibles could be the ideal investment for investors “hooked” on stocks, as we go through this recession. A convertible has an investment value (a bond value); it pays income, which is generally higher than that of the stock; and the warrant portion gives holders a call option on the underlying stock when equity markets perk up again. And, they are more stable than stocks.
Historical studies show on a total-return basis that convertibles, in general, offer competitive returns to equity returns (sometimes slightly lower depending on the time frame) with much less risk. As a result, on a risk-adjusted basis, convertibles offer one of the highest reward/risk ratios of all investment instruments. The traditional convertible bond or preferred stock is a hybrid instrument that can be broken down into two key components: a fixed-income debt instrument and a warrant on its underlying equity. The price at which a convertible trades is the combined value that the market places on both of these components. Hence, an issue’s fixed-income value or its warrant value can be viewed as floors, below which the convertible should not trade, unless the market expects a change in the fundamentals of the underlying company (i.e., the investment rating of the company is downgraded or the economy goes into a tailspin.) These floors provide downside protection if either the equity market or bond market moves against a position. Since most convertible securities have a yield advantage over the underlying equity interest, this yield advantage also provides a cushion against a decline in the underlying stock. Although only a few convertibles will participate in 100% of the gains in the underlying common, over time, the yield advantage convertibles offer usually produce total returns that are very close to equities. Furthermore, because part of the value of the convertible depends on the underlying common stock, if the stock is trading near the conversion price—the price per share offered upon conversion—any gain above that price is added value to the convertible. If the stock is trading below conversion price, the convertible tends to trade on its bond (or investment) value.
Conversion Value and Investment Value
Because convertibles (bonds or preferred stocks) can be exchanged for the a pre-determined sum of the underlying equity, as the underlying stock price fluctuates, the convertible can take on the features of an equity surrogate, a fixed-income debt instrument or a combination of both. The key to a convertible’s exposure to the movements in either its underlying stock price or interest rates in the fixed-income market is the relationship between the convertible price and its conversion value and investment value. The conversion value of an issue is usually a straightforward calculation: the number of common shares for which the issue may be exchanged multiplied by the price of the common. The result, however, could be affected by certain corporation activities; for example, in the case of a spin off, an issue can be become convertible into more than one company, or in the case of a merger.
The investment value of a convertible is its value as a straight, non-convertible debt instrument. In general, buyers of convertibles accept lower yields than for straight debt instruments of the same company because the warrant portion (the conversion privilege) gives holders a play on the underlying equity. As opposed to conversion value, the investment value of an issue is much more difficult to calculate because it depends on factors such as maturity, call risk, the issue’s investment-grade quality, and coupon size. Subsequently, it is common for different analysts to have different estimates of an issue’s investment value.
Conversion Premium, Investment Premium, and Leverage Projections
Once an issue’s conversion value and estimated investment value are established, it becomes easy to understand why most convertibles trade at a premium to these values. As mentioned, the typical convertible provides a higher yield than its underlying stock and is ahead in line for assets of the company and, hence, higher quality. Were a convertible to sell on its conversion value, sellers would be giving away the higher yield for free. On the other hand, if a convertible was sold at its investment value, the seller would have given away the warrant option. As a result, a convertible will normally trade at a premium to both of these values.
A convertible’s premium over conversion value is simply the amount by which the price of the convertible exceeds its conversion value, stated as a percentage. Likewise, an issue’s premium over investment value is how much a convertible’s price exceeds its estimated investment value, again usually stated as a percentage.
As stated, an issue’s conversion value and investment value can be used as floors below which the issue should not trade unless market fundamentals change, thereby triggering a change in the fundamentals of the underlying stock. Therefore, an issue’s premium over conversion value and its premium over investment value will indicate how sensitive that issue will be to changes in the price of the underlying stock or interest rates. Leverage projection is based on this relationship and indicates the degree to which the convertible should participate in equal up or down moves in the common, providing interest rates remain flat. Typically, convertibles demonstrate favorable leverage, rising more than falling on equal corresponding moves in the underlying common stock.
Why Should I Consider a Convertible to the Outright Purchase Of The Common Stock? If it could be predicted that a stock’s price will rise in the near term, then by all means, an investment in the common stock would more than likely yield a higher total return. However, equity markets, largely down the last two years, are often volatile. Furthermore, in average years, where equity indices post gains of about 10% on a total return basis, it is not unusual to find the average convertible yielding higher returns due to the yield advantage.
Again, as a convertible’s underlying common price moves up or down, the convertible will take on the characteristics of an equity surrogate, a straight bond or will be sensitive to both markets, as its value reflects the movement of the common and the shift toward the conversion value or the investment value. Therefore, in terms of a portfolio’s objectives, convertibles can cover a broad spectrum of investment alternatives from virtually pure fixed income plays to pure equity plays.
All in all, the decision of whether to invest in the common or the convertible, if one is available, will be up to the individual investor and his/her investment objectives. So, keep in mind that convertibles in general are conservative investment instruments that offer competitive returns vis-àvis the common stock, with downside protection. Convertibles are a prudent addition to any portfolio.