With the equity markets behaving in a more volatile manner than usual, particularly on the downside, convertibles have gained in popularity of late. More than ever, investors are looking for securities with some price stability; more protection from the downward spiral in the equity markets. Focusing on convertibles trading with smaller, if any, premiums over investment value and large premiums over conversion value, may provide some solace for investors who are bold enough to investy in these choppy seas. Convertible securities that fit this premium profile are called “busted” convertibles, and will usually offer much higher current yield than the average convertible, along with yields to maturity that compare favorably to non-convertible bonds. In theory, a convertible trading on its investment value tends to be insensitive to movements in the underlying common stock. However, does this perception hold up on the trading floor? This week we will discuss investment value and our views of just how much downside protection can be expected. But let’s first review briefly some fundamental convertible relationships.
The most basic definition of a convertible security suggests that it is a combination of a fixed-income instrument and a call option. The fixed-income part is referred to as its investment value, while the call option is expressed by its conversion value. A convertible will trade at a price that is at some premium to each of these values. As such, the relative attractiveness of a convertible will be derived from the interplay of these two components.
To illustrate, consider that most investors buy convertibles because the coupon or dividend provides a steady income stream, like any fixed-income security, along with the potential to share in price increases in the underlying stock via the imbedded call option. The convertible also usually offers a higher yield than the common that it can be exchanged for. This yield advantage contributes to the estimation of the investment value and helps give the convertible some downside support. At the same time, the option component will assure holders that if the stock trends higher, the convertible will participate to some extent. The combination of downside support provided by the yield advantage, the fact that holders typically get the face amount of the bond back at maturity, and the upside potential provided by the option, helps explain why these securities tend not to fall as much as rise on equal moves in the equity.
The floor value beneath which a convertible should not trade is called its investment value. In theory, once the investment value is determined, the level of downside exposure to the common should be known. Investment value is actually the present value of the income stream, discounted at a rate that would approximate the yield of a nonconvertible bond of similar credit worthiness. The variables used to solve for investment value include the coupon, settlement and maturity dates of the security, and the appropriate yield estimate.
The yield estimates we use for our investment value calculations can be found on the back page of our publication and the resulting values can be found in Column 38 on pages 6 through 27. The yield that is used is based on the I.V. Grade found in Column 37. The I.V. Grades correspond loosely to those of the major rating agencies. For our purposes, grades A through D are considered investment grade; E through I can be viewed as varying degrees of “junk ratings”; J is considered highly speculative; K is for those bonds we think are default candidates, and for preferred stocks in arrears. I.V. Grade L is reserved for those companies that have declared bankruptcy. We do not list investment values for companies with I.V. Grades of J, K and L because they are truly guesses, at best, and do not actually provide even the theoretical support that an investment value should, for reasons we will soon discuss.
Another factor to consider when evaluating investment values is the credit spread. The credit spread is actually an attempt to quantify the credit worthiness of a company, or its ability to make timely interest and principle payments. It is often viewed as the premium over a risk-free rate investors demand to justify the greater inherent risk in the security. The U.S. government for example, is considered risk-free (it can always print money or raise taxes to make interest and principle payments), so the yields on government debt issues are used as proxies for various risk-free rates by maturity. A security trading with a yield to maturity that is 600 basis points (100 basis points = 1%) over the corresponding riskfree rate, for example, would suggest that investors are not convinced that timely payments will be made. A higher yield is demanded to justify the higher perceived risk. A security that trades 40 basis points over the appropriate risk-free rate, on the other hand, would mean investors think the credit is quite stable, and in fact settle for a yield that is much closer to the risk-free rate.
Interest Rates, Spreads and Investment Values
During periods of increased interest rate volatility, investors will often demand a wider (larger) credit spread, leading to lower investment values. Higher rates hurt balance sheets by raising variable interest costs, among other things. The added cost of doing business could create the perception that the company might have a tough time making timely interest and principle payments, which would be reflected in a wider spread. Of course in a lower interest rate environment, like the one we have been enjoying, spreads would likely narrow, leading to higher investment values. However, it is also important to consider that credit spreads will often move regardless of the direction in interest rates. If the issuer is having liquidity problem, the spread could widen, causing the investment value to drop, regardless of the direction of rates.
Wrapping Up the Investment Value Perception
Investment values are very important when evaluating a convertible. If a bond is trading at 85, and its investment value is 84, then the bond theoretically has only about 1% of downside risk. A bond like this should be insensitive to moves in the common stock, up or down. Investors should not be lulled into a false sense of security, however. Although analysis of financial ratios, the balance sheet and statement of changes is necessary to determine the company’s liquidity, and the likelihood of interest and principle payments, the common stock price should also be considered. After all, there isn’t a surfeit of AAA-rated companies whose common stocks are trading in the low single digits.
Does this mean credit analysis should not be used to determine downside risk? Absolutely not! For the majority of convertibles, the estimate of investment value will provide a very good indication of downside support and the credit worthiness of the company. Indeed, all financial calculators have functions that make it possible for any investor to determine investment value. Simply ask yourself the question, “What would this bond have to yield if the stock dropped 50%”? Enter that value for the yield, enter the settlement date, maturity date, and coupon, and solve for price. That will be the investment value.
Investors should be careful when considering high yielding bonds with theoretically little downside risk. If a company’s financial condition is suspect, chances are it will be reflected much sooner in the common stock than in the credit rating. While that stock is dropping, the spread will likely be widening, leading to a lower investment value and a lower bond price. In our experience, once a bond starts trending toward the 60 or 50 level, it is time for the professional speculators and yield vultures to step in, because chances are it will be heading lower before it trends higher. At this point, the market is effectively telling you what it thinks the investment value is. For example, in theory, a bond trading at 50, with an investment value of 49 should be insensitive to further drops in the common. But if the stock is down because the company is posting losses, and cash flow is weak, traders will likely take the bond down as the stock goes down. So, if the stock drops 20%, it is very safe to assume, and indeed should be expected, that the convertible is going to share in a significant degree of the common’s drop, regardless of its estimated investment value at the time. Investors who are comfortable dissecting financial statements might find real opportunity in these cases. But most investors should err on the side of caution. There will be plenty of time to participate in a recovery as a bond moves from 50 to 60 to 70. On the other hand, it might be difficult to bail out as the bond goes from 50 to 40 to 30.
It is not uncommon for some of the convertibles under our evaluation to trade at discounts to investment value. The yields we use are estimates; it is not uncommon for the spread of a given investment grade to range 50 to 150 basis points. So a “low” F might be showing an investment value that is 5% higher than the current price. This may be an opportunity worth further consideration. If the discount is higher than that, chances are a downgrade may be in the works, and investors should probably look elsewhere.
Finally, it is possible that a security like this could be ranked 1, simply because the leverage profile and yield would appear so attractive. But that doesn’t mean we will recommend it. In fact, unless the common stock shows significant improvement, as reflected in the underlying stock rank, chances are it will never have a place on our Especially Recommended List, and only the most risk-averse investors should consider it for purchase.
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