The Value Line Convertibles Survey

Relative Volatility: Our Measure of Risk

Volatility is a major factor in the construction of a portfolio. As the markets gyrate, prudent investors are constantly on edge and find themselves second-guessing their investments, which could potentially lead to regrettable investment decisions. Well, nothing is sure in this world except death and taxes. But investors seek ways to reduce losses by turning to safer investment instruments like Treasury bonds and corporate debt instruments such as convertible bonds and convertible preferred stocks. These latter instruments can provide some degree of downside protection vis-à-vis the underlying asset. Although the value of convertibles depends on the activities of the underlying stock, investors in convertible securities have some peace of mind knowing that their investments are relatively safe compared to common stocks because of the convertible’s defensive nature. In an up-trending equity environment, convertibles offer investors both a play on the equity (because of the warrant portion), as well as the benefits of a fixedincome security (the bond portion), which enhances downside protection.

The risk involved in any security is the probability of realizing a return from an investment.The greater the risk, the greater the expected return. Relative Volatility is one way The Value Line Convertibles Survey measures the risk of a convertible in relation to the volatility of the common stock. Each quarter, The Value Line Investment Survey calculates the standard deviation of the natural log of weekly price changes over a 5-year period of the stocks covered in the Value Line universe (Standard and Small and Mid-Cap Editions). The median number—the latest number for the June 2009 quarter is 5.7514—is used as a benchmark from which to compare all other stocks. This median stock is assigned a Relative Volatility (RV) of 100%, and the RVs of other stocks are based on their relationship to the median stock. For example, a stock with an RV of 50% would only be one-half as risky as the median stock, while a stock with a RV of 200% would be twice as risky as the median stock.

Relative Volatility of a Convertible

Calculating the relative volatility of a convertible is more complex. While the relative volatility of common stocks is derived from historical price movements, the relative volatility of convertibles (and warrants) takes into account additional features of the securities. Fluctuations in the price of convertible bonds or preferred shares are affected by fluctuations in the price of the underlying common. However, the level of sensitivity the convertible has to movement in the underlying common depends on how close the price of the convertible is to its conversion value—the value of the convertible when converted into common shares. Convertibles trading at a low premium over conversion value tend to have a greater degree of sensitivity to moves in the underlying common stock. On the other hand, convertibles trading at a high premium over conversion value—referred to as “busted” convertibles— tend to show virtually no sensitivity to the underlying common stock, and trade on the fixed-income portion (or investment value) of the security, with greater exposure to bond market risk. Therefore, the relative volatility of a convertible is a combination of its exposure to both stock market and bond market risk. The amount of participation a convertible has in the movement of its underlying stock is expressed as its leverage.

The calculation of the Stock Market Risk (which can be found in Column 35, pages 6 thru 27) is relevant to the convertible. We simply add the leverage projection numbers for a +25% and a –25% (disregarding the signs) move in the underlying common stock. Then divide the sum by 0.5 and multiply the quotient by the relative volatility of the stock. That number, rounded to the nearest multiple of 5, is the Stock Market Risk expressed as a percentage. In general, convertibles that trade at a low premium over conversion value tend to have greater stock market risk. And, all other things being equal, the lower the convertible’s premium over investment value, and the higher its premium over conversion value, the lower the issue’s exposure to stock market risk will be. Hence, the lower its relative volatility compared to the underlying common stock.

The fixed-income portion of a convertible (the bond portion) is exposed to the same factors, interest rate changes, and changes in investment quality that also influence non-convertible bonds. Hence, the Bond Market Risk (Column 36). Convertibles with smaller coupons and long maturity, especially zero-coupon bonds, will be most affected by changes in interest rates. Also, changes in interest rates tend to adversely affect convertibles with low investment-grade quality to a greater degree, since rising interest rates tend to reduce investment value. Needless to say, convertibles with low-coupon, low investment quality, longer-term to maturity, and low premiums over investment value tend to have the greatest bond market risk exposure. Thus, our leverage projections (in Columns 29 through 32) are based on the assumption that interest rates and investment grades will remain the same, and leverage projections only reflect anticipated movements in relation to upward and downward moves in the underlying common stock.

In addition, the bond market risk of a convertible is also linked to the creditworthiness of the issuing company, and companies can become more risky due to possible downgrades in investment quality. However, because of the higher investment quality, convertibles generally are more price-stable than their underlying common stocks. Be aware that convertibles trading at a deep discount to investment value often indicate the market’s expectation of a downgrade in the issue’s investment quality.

Volatility and Portfolio Diversification

If convertibles are in your future and you are considering their inclusion in your portfolio, you must first determine the amount of acceptable risk involved. Furthermore, by diversifying your portfolio, you can reduce the overall risk, but be mindful that the total amount of risk depends on the risk associated with the individual issues in the portfolio.

Spreading your investments across several different issues in different industries will significantly reduce the effect of an unanticipated loss in any one issue. As the number of issues in a portfolio increases, the volatility of that portfolio tends to decrease to that of the overall market. However, it is not necessary to own all of the issues in a market in order to attain a reasonable level of risk. Portfolios with 10 to 15 issues in eight or more unrelated industries are considered well diversed. Beyond this point, the rule of diminishing returns takes effect. Furthermore, as the number of issues increases, managing the portfolio effectively becomes increasingly more difficult.

On occasion, it may not be possible to build a portfolio with modest volatility, but the number of issues necessary to diversify may not be available. In this case, an investor should choose issues from different risk groups. Structuring your portfolio based on the relative volatility of the issues also offers additional opportunities to diversify.

Summary

The relative volatility of a convertible is a function of the relative volatility of the underlying common stock, as well as the convertible’s sensitivity to changes in stock price and interest rates. Some convertibles will move with the underlying stock, while others will behave more like a straight bond. Regardless of the type of convertibles held, diversification will play an important part in building a portfolio. This will enable an investor to reduce risk specific to an industry or company, thus reducing the overall risk of the portfolio.

Convertible issues listed on our “Especially Recommended” and the “Hold and Sell” tables (on the second and third pages of this section) are divided into four relative volatility (or risk) groups—the High Risk group, which is reserved for warrants; the Above Average (RV 95% and over), the Modest (RV 65% to 95%), and the Low Volatility (RV 60% and below) groups. Investors can use our volatility groups to tailor their holdings according to their investment objectives. If an investor is riskaverse, and not willing to deal with large, unexpected losses, a low- to modest-volatility portfolio of convertibles is recommended. If, on the other hand, an investor is seeking more growth and less income, he or she may prefer to add some riskier investments with above-average profit potential.

Prepared by :George Graham
Editor