Buying Convertibles on Margin
The strategy of buying securities on margin allows investors to leverage a position by obtaining an interest-bearing loan from a broker in order to purchase a greater dollar amount of securities. Using margin to leverage a position, however, increases the risk of the position. If a margined position moves as expected, the owner will generally receive a higher total return than on a position that is purchased outright. On the other hand, a greater loss can be expected if the market moves against the owner’s position.
As a general rule, brokerage houses require investors to have capital available in their account to cover at least 50% of the position being purchased. For example, in order for a single trade of say $10,000 to take place, an investor would have to deposit at least $5,000, plus commission costs into his/her capital account with the broker. On the other hand, if you have a portfolio of securities worth $10,000, and all are marginable, you can borrow (margin) up to an additional $10,000, less commission costs. Stocks trading above $5.00 and most bonds can be used as collateral to purchase the additional securities.
For an investor to open and maintain a margin account, most brokerage houses require a minimum net portfolio value. Usually, if the net value of your portfolio (total value - margin loan = net value) declines about 25% of the portfolio value (25% net value, 75% margin loan), investors on margin may be subjected to a margin call, having to deposit additional funds into the account before the market closes, or sell securities to reduce the loan. If the brokerage house cannot contact you, or the funds do not arrive before the market closes, the brokerage house can and usually will arbitrarily sell off part of the portfolio to bring the loan percentage back to between 25% and 50%.
Buying convertibles on margin allows investors to leverage capital invested in convertibles to attain greater participation in the appreciation of the underlying common shares. However, this added participation is not free, as some of the downside protection and yield advantage over the common will be lost. Still, the convertible’s higher yield is a big attraction to margin investors, because the net interest cost of carrying a convertible will be lower than the margin cost of carrying a low-yielding (or no-yield) stock.
Leverage and Margin
When we talk about leverage in regard to convertibles, we think in terms of the degree to which a convertible is expected to rise or fall with its underlying common. Leverage is dependent on the relationship between the convertible price, its conversion value, and its investment value. Conversion value, as the name implies, is the value of the security when converted into the underlying common stock, and is equal to the price of the underlying common stock (or unit) times its conversion ratio. An issue’s investment value is the estimated value the convertible would command if it were a “straight” non-convertible bond or preferred stock. Both levels represent floors below which the convertible should not usually trade—unless the financial strength of the issuing company is perceived by the market to be deteriorating, or market rates of interest rise (both of which will reduce the issue’s investment value). As a convertible’s price approaches its conversion value, the issue becomes more sensitive to any rise or fall in the price of the underlying common. On the other hand, as an issue’s price approaches its investment value, the convertible will behave more like a straight bond or preferred stock, with limited exposure to declines in the common and usually minimal participation, if any, in the advances of the stock price. But the issue will be highly sensitive to changes in interest rates. In some cases, convertibles will trade with low premiums over both conversion and investment values—an ideal combination that maximizes the upside, while minimizing the downside.
Convertibles will almost always trade at a premium over conversion value. This premium reflects the value of the warrant component of the issue and the superior yield afforded over the underlying common stock. (Except in the case of callable issues where the conversion value exceeds the current call price, and the market perceives that the issue is a likely call candidate. In this case, the premium over conversion value will gradually disappear—especially if the premium over investment value is high—and the convertible will closely track the movements of the underlying common stock.) Again, the magnitude of an issue’s premium over conversion value will determine its potential to share in the upside of the underlying common stock. A quick scan of the convertible leverage projections in Columns 29 through 32 on pages 6 through 27 will show that few issues are expected to rise in step with the common due to the magnitude of the premiums over conversion value. Still, if you are bullish on the underlying common, but want the downside protection convertibles offer, by purchasing convertibles on margin and tailoring the position to the upside leverage of the convertible, greater participation in the appreciation of the common can be attained. For example, if a convertible is expected to capture only half of any rise in the common, in order to participate in the full rise, it would be necessary to double the amount of convertible you buy for each dollar you invest. The only way this could be accomplished would be to buy the convertible on margin, i.e., using an interestbearing loan from your broker.
Setting Up the Strategy
Let’s consider a hypothetical case. Say, the ABC Corp. 5¼% convertible bond due 2020 was priced at $1,159.40, with the underlying common at $19.06. The bond is convertible into 55.34 shares of the ABC common. At these price levels, the convertible trades at a 10% premium over conversion value and a 22% premium over investment value, based on the estimation of straight bonds with similar terms and quality. Our leverage projections are as follows:
Com: +50% +25% -25% -50%
Conv: +40% +19% -4% -10%
Based on these projections, if ABC advances 50%, the price of the convertible is expected to rise 40%, or in other words, share in 80% of the common’s rise. (This can easily be determined by multiplying the leverage projection of +40% for a +50% move in the common by 2, or by dividing 40% by 50%.) If a 25% gain in the common was expected, the bond is projected to rise 19%, or share in 76% of the increase (calculated by multiplying the expected leverage for a 25% gain by 4, or by dividing 19% by 25%). In either case, the convertible’s expected participation in the gains of the common represents the optimal percentage we would want to put up in cash, with the remainder on margin, in order to maximize participation in upward moves in the common. Thus, on an expected 50% gain in NET, an investor using this strategy would put up $927.52 (80% x $1,159.40) for each bond, and borrow the remaining $231.88 from the broker. On a smaller expected move of a 25% gain in the common, an investor would put up $881.44 (multiplying the leverage projection of +25% move in the common by 4, multiplied by $1,159.40) and put the remaining $278.25 on margin. If we assume a 50% gain in the common over the following year, and since 80% of the convertible’s price would be paid for in cash and the remaining 20% borrowed on margin, the effective leverage for the position can be determined by dividing the original leverage projections by 80% (e.g. 40%/80% = 0.5 or 50%). Thus, the new leverage projections would be:
Com: +50% +25% -25% -50%
Conv: +50% +24% -5% -13%
By margining the convertible position, investors are now more likely to capture almost the full upside potential of the common stock on a large move in the common. Although the position is still favorably leveraged, notice that the position now has greater downside risk. The old adage “there is no such thing as a free lunch” once again holds true. The cost of gaining additional upside potential is giving up some downside protection if the common’s price declines.
The final questions that remain are whether the position will result in a carrying cost (due to the margin expense), or a credit (where the current yield on the convertible exceeds the margin rate) and whether the position is worthwhile to create. The answers to these questions depend on whether the broker’s loan rate is lower than the current yield on the convertible and how much of the position will be put on margin. In our example, the ABC Corp. 5.25s2006 bond has a current yield of about 4.5% versus a “non-dividend-paying” common. Using a sample broker’s margin interest rate of 2.75%, results in a 1.75% yield disadvantage for each dollar of the convertible that is put on margin. Still, each ABC Corp. bond pays interest of $52.50 per year, and by deducting the yearly cost of $231.88 on margin at 2.75% (about $6.38), investors would realize a loss of $46.12 ($52.50 - $6.38) for each bond on margin. As this example demonstrates, the carrying cost (margin interest paid versus income received) must always be considered before embarking on this strategy.
Margin requirements and the interest rates charged for funds on margin differ from broker to broker, but are generally close to the prime rate. In addition, in many brokerage houses, the larger your portfolio, the more favorable your margin rate of interest. As we have shown, investors need to look at each convertible and decide whether the ratio of cash to margin is appropriate to make the strategy profitable. For example, if you are just setting up an account and have no marginable securities, and if you have to margin more than 50% of the convertible’s price for this strategy, your broker will not likely allow the trade until your account meets the minimal 50/50 (at least 50% of the securities paid for in either cash or other securities and 50% on loan - i.e., margined) margin requirement. Separately, investors should note our leverage projections are based on the issue’s investment value remaining constant. Therefore, changes in market rates of interest, or a company being upgraded or downgraded in investment quality can impact expected returns on a position. This strategy is primarily used by investors who are bullish on the underlying common of a convertible and want to increase exposure, yet have some downside protection if the common declines. As a result, conservative and riskaverse investors may find the tradeoff of upside potential for downside protection too risky.