Convertibles are an interesting hybrid of stocks and bonds. There are a lot of questions that an investor new to this market might ask. Here are some valuable questions to which we think you need to know the answers.
What is a convertible security?
A convertible is a bond or a preferred stock that can be exchanged for another security, usually the common stock of the issuing company. Convertible bonds and convertible preferred stocks are hybrid instruments that can be broken down into two key components: a fixed-income debt instrument and a warrant on its underlying equity. Usually, the conversion privilege lasts for the life of the bond, or for the life of the preferred stock, although in a few instances, the number of shares of common for which the convertible can be exchanged may be adjusted during the life of the convertible.
Why are convertibles issued?
Corporations usually sell convertible bonds and preferred stocks when other means of raising capital would be more expensive. The conversion feature is a “sweetener” to persuade investors to accept a rate of interest on a bond or preferred stock that is below prevailing levels. The loss in yield is, presumably, made up for by the fact that the value of the convertible security will rise if the stock rises in value.
What gives a convertible its value?
A convertible’s value is drawn from its conversion privilege and from the value it commands simply because it is a bond or a preferred. While its price rises with its conversion value (that is, with a rise in the stock of the issuing company), its price will normally fall no lower than its investment value (the value of the bond or preferred).
However, convertibles will almost always sell at premiums above both their conversion and investment values. This is so because a convertible that is bought at its investment value provides the conversion privilege for free. And, conversely, a convertible purchased at its conversion value would provide the investment value free of cost. “Free” isn’t something that lasts long on Wall Street, so, under normal conditions, the prices of convertibles are bid up to reflect the value of both the investment value and the conversion privilege.
Why buy convertibles rather than common stocks?
Here are some of the many reasons:
1. Convertibles are almost always less risky than the common stock of the issuing company.
2. Convertibles almost always provide greater income than the common stock of the issuing company.
3. Fairly priced convertibles tend to rise more than they will fall on an equal move, up or down, in the price of the underlying common stock.
4. Over longer periods of time, convertibles have tended to perform as well or better than common stocks when both income and price appreciation (total return) are measured. Note, however, that when the market rises rapidly, convertibles generally tend to lag the common in performance, but in a market decline convertibles will generally hold up in value better than common equities.
Why do convertibles usually outperform common stocks?
That is easily explained by looking at what happens in various phases of the market. Generally speaking, convertibles not only fall less than common stocks, but they provide greater income in a falling market. In a flat market, the fact that convertibles tend to provide a larger income stream than stocks provides an edge. In a rising market, convertibles do not normally appreciate in price as much as the common, but if the market rise is slow, the greater income provided by convertibles often results in the total return from convertibles equaling or surpassing the total return from common stocks. Only in a rapidly rising market do convertibles typically lag materially behind stocks.