The Value Line Convertibles Survey

FAQs

Subscribers sometimes find the material in our publication overwhelming and, at times, frustrating when trying to trade convertibles. Here are the answers to some of the most frequently asked questions.

Q: Which Especially Recommended issue should I choose?

It is customary to add at least one new recommendation to our Especially Recommended list (which appears on page 3 of this publication) every time the survey is published. This question is also posed as “Which recommended issue is best to buy?!! Honestly, there are no straight answers to these questions. Selecting an issue is solely dependent on an investor’s individual goals and strategy.

Our list of Especially Recommended convertibles is broken out into three risk categories based on the relative volatility of the convertible. The groups are Above Average, Modest, and Low volatility. Actually, there are four groups but one group, High Risk, is reserved for warrants only. Needless to say, the higher the volatility, the greater the return expected. On the other hand, higher volatility also offers the prospect that losses can be greater than lower-volatility issues. Within each risk group, all issues have attractive reward/risk ratios, and no one issue is more attractive than another because different issue will suit different investors’ goals. Within each volatility group, some issues will be equity plays, attracting aggressive investors, while others are yield plays, attracting more-conservative investors seeking income, and some could possess both qualities and attract either type of investor. Furthermore, the investment quality of each issue will vary. Some may be of investment-grade quality, and others below investment-grade quality. But again, the attractiveness of any issue will depend on the prospective investor’s mindset; the decision is solely the investor’s.

When selecting convertibles to buy, an investor should first choose a level, or levels, of volatility tolerable to him/her. Then decide whether your selection(s) is going to be an equity play, a bond play, or both. This can be determined by the issue’s premium over conversion value, premium over investment value, and the projected leverage for equity for participation. If the premium over conversion value is low, its leverage on the stock will be high, and the convertible becomes an equity play. On the other hand, if the conversion premium is high, but the premium over investment value is low, the convertible could be suitable as a yield play, with minimal or no exposure to movements in the underlying stock. The convertible’s investment-grade is another important factor. Our investment grades range from A (Highest and least likely to default) to L (Lowest and in bankruptcy). Issues with investment grades ranging from A to D are considered investment grade quality, and those that have investment grades of E, F, and G are regarded as junk. Last, but not least, we recommend investors search out and buy fairly liquid issues, those with liquidity grades of 1, 2, or 3.

Investors should also note that it would be virtually impossible for an average investor to be positioned in every issue we recommend. As a result, your own personal preferences toward an industry or a company will also play a part in making selections. 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.

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 Allied Waste Industry 4.25s2034 identifies the issuer as Allied Waste Industry, the coupon as 4.25%, or $42.50 per annum, the “s” is a break point that also helps to identify it as a convertible bond, and 2034 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 math here. The TWX (Liberty Media) 0.75s2023 is an example of where the issuer is Liberty Media, but the issue converts into common shares of Time Warner (TWX). The symbol TWX is because of space limitation.

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 they have a small account. Underwriters of an issue are usually looking for large orders of at least $250,000, and up, to subscribe to the deal . In recent years, most new convertible issues are sold under SEC Rule 144A and, as such, only to institutional investors (like pension funds) and fund managers in control of more than $100 million in net asset value. 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.

Still, the new issue market can be risky; initial price talk can change when the issue is finally priced, and individual investors have to be careful of being offered highrisk, low-quality issues that institutions tend to avoid. These issues generally usually have very low liquidity in the aftermarket. On the other hand, hot issues are often oversubscribed, and it not unusual for instituinstitutions to receive only a fraction of the amount they ordered. Overall, for the average investor there are many opportunities in the universe of convertibles that trade in the aftermarket 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 usually have narrow bidask spreads. Because 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 wider 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 a small-lot trade, be aware of the price at which it is being executed and watch 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’s 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. By diversification, the risk of all issues in one’s portfolio is decreased, 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.)

Q: Is it possible for individuals to achieve the quarterly total return performances of the Especially Recommended issues.

For an individual to approximate the total return performance of our recommended issues, either as a whole or for a volatility group, a portfolio would probably need to contain a large number of our recommendations. However, there is no particular reason to expect underperformance in a portfolio consisting of only a small number of our recommended issues. As in any investment vehicle, some issues will go up and others down. If the portfolio is properly diversified— having at least five to 10 issues— individual performance can even exceed our published results. Bear in mind, however, that our performance results do not include commission costs nor do they take into account the various hedge strategies that can also add to a portfolios performance.

Summary

In general, convertibles offer very attractive and competitive total returns with less risk when compared with common stocks. Historically, total returns from convertibles have usually been superior to returns from straight bonds, and have often equaled or surpassed total returns from stocks, riskadjusted of course. We think convertibles can be a rewarding addition to any portfolio no matter what size, as convertibles are less risky and almost always provide greater income. Moreover, fairly priced convertibles are almost always favorably leveraged— that is, they will rise more than they will fall on an equal move, up or down, in the price of the underlying common stock. However, when the market rises swiftly, convertibles will generally lag the market. But over time, convertibles have consistently outperformed common stocks when both income and price appreciation are measured.

George S. Graham,
Editor