|For some, the current poster children for what can go wrong with convertible securities are the convertible bonds issued by Amazon.com. The online retailer, which with its expanded product line of everything from books to ski equipment has yet to make a profit, has relied on convertible bonds as a major source of capital. But as Charles Lieberman, chief economist and investment strategist of Advisors Financial Center notes, this strategy has its downside. "If you continue to lose money, you have to pay the interest or dividend on the convertible. And that huge convertible bond that Amazon issued has proven itself to be something of a problem, because the interest cost is high and the stock has fallen sufficiently that the conversion feature has little value." |
Lieberman says he doesn't believe there is any particular "creditworthiness" problem with convertible securities in general, however. "I think each convertible has to be evaluated individually," he says. "If you buy the Amazon convertible bonds, you're buying into a security of Amazon. It doesn't matter to you how risky or safe somebody else's convertible is, you have Amazon risk. And that's what you should analyze."
Russell Cleveland, president and CEO of Renaissance Capital, a top-ranked, closed-end fund specializing in convertible issues, agrees. "You can't generalize; some of these convertibles are safe and others are just total speculation. You must look at the underlying company as though you were buying common stock. The key to the game is not the convertible itself" - which he notes is "just a vehicle" - "but what does [the convertible] convert into?"
"Convertibles are basically hybrids," Lieberman explains. "They're crosses between common stock and bonds. And so they have the characteristics of both, just like a hybrid would. They're a security that pays a fixed rate of return, just like a bond. But they can be converted typically into common stock. So depending on what happens to the price of the stock and what happens to interest rates, that will affect the price of the convertible, whether it's a convertible stock or a convertible bond."
Corporations have a range of options available to them to finance growth. Foremost, and most preferably, corporations fund growth through the revenues produced from the goods and/or services they sell. Another option, of course, is by taking on debt. Corporations will issue bonds and sell them to raise the necessary capital. When the time comes to redeem the bonds, the corporation hopes to have grown enough to pay off the bonds with little financial difficulty.
Convertible securities represent a third option for many companies who may find it difficult to raise capital by issuing common stock or corporate bonds in a cost-effective manner. By making the bonds or stocks convertible into common stock, corporations hope to pique the interest of investors who might have been unimpressed by straight bond or common stock offerings from the company.
"Typically, in the case of technology companies," says Lieberman, "they believe they have enormous growth potential and they are financing that growth. And they typically need a lot of capital to finance that growth."
The convertible character of the securities does make them more attractive to investors in many ways, but the fact that the securities were issued as convertibles also means there is likely to be some significant risk involved with the company's near-term outlook. Studies conducted by Dow Jones and others suggest that the majority of convertible bonds, for example, are less than A-rated by the major bond rating agencies such as Moody's, Standard & Poor's, and Fitch's. This means there is a far greater risk of default with these convertibles than there would be with bonds of a higher rating (A or above). While convertible bonds are often sought after for their low correlation with bonds and stocks, as well as the healthy coupon, they are not immune from the risk?reward equation. What the fixed-income portion of convertibles brings in minimizing risk can be undermined if the convertible itself is on shaky credit ground.
WHAT ARE THE RISKS?
Although the convertibles holder generally reserves the right to determine if and when his or her convertibles will be exchanged or converted into the predetermined number of common shares, there are some circumstances under which the issuer of the convertible can, in effect, "call" the convertible and force it to be converted into common stock. Says Lieberman, "What typically happens with a call feature is that the company wants to get rid of the convertible, but the price is such that it typically makes sense for the owner to convert it into shares [of common stock]."
Cleveland suggests that there is "always a call provision" of one sort or another. He notes two different types of calls: One is a time limit ("no call for three years") and the other - which Cleveland's firm Renaissance Capital uses often in private placements of convertibles - is based on stock appreciation. "We say, OYou can call us at any time if your stock goes up three times.'" Sometimes, a convertible will have a combination of the time-limit call and the percentage appreciation call (no call for x years and you have to have a certain amount of appreciation as well, according to Cleveland). Finding out exactly what call provisions might have been attached to any convertible security before purchasing it can prevent maddening phone calls down the road.
Another form of risk for the convertible security buyer is stock depreciation risk. While the bond character of the convertible limits the amount of downside risk the holder will be exposed to should the underlying stock begin to fall, depreciating stock prices should not be seen as a boon for convertible holders. Depending on the degree of the decline, holders of convertible securities of company A will generally fare better than common stock owners of company A, should the price of company A's stock drop significantly. But the holders of company A convertibles are likely to see the value of their convertibles drop off somewhat, all the same.
The greatest risk of a convertible issue, however, is default - the possibility that the issuing company will be unable to pay interest/dividend payments. It is to avoid default that convertible buyers closely study the debt rating of each convertible being considered for purchase, as well as the financial fundamentals of the underlying company. In the event of default, what Lieberman calls "a pecking order" takes over. When companies are unable to pay their interest or dividends, common-share holders are the first to lose out. But convertible stockholders are right behind them.
WHAT ARE THE BIGGEST REWARDS?
There are four principal benefits that investors seek when purchasing convertible securities. All of these factors often conspire to make convertible securities less risky than stocks, with greater upside than less speculative instruments such as Treasury bonds:
HOW TO SPOT A TOP CONVERTIBLE
Because a convertible security is first a debt instrument, one thing you should check before purchasing a convertible is its debt rating. Available through Standard & Poor's, Moody's, and Fitch's rating services, debt ratings help determine the creditworthiness of debt instruments such as bonds and convertibles. Moody's debt ratings, for example, range from Aaa for investment-grade bonds considered to have the lowest amount of default risk, to Baa, which includes bonds that are believed to be sound yet are not well-protected and may have speculative elements, to Caa for bonds from companies teetering on the precipice of bankruptcy or suffering from some other financial difficulty. The debt ratings from S&P are similar in structure to those of Moody's, while Fitch's system differs somewhat.
But Cleveland, whose Renaissance Capital was ranked the no. 1 convertible closed-end fund in 2000 by Lipper Financial, points to what he believes is an even more important factor in choosing convertible securities, the conversion premium.
"If you have a convertible and the stock is trading for $10 a share, and you can convert it at $10 a share, you're essentially in the money," Cleveland explains. By "in the money," he means that the convertible buyer or holder is in a better position compared to the common stockholder because the convertible can be converted into the market price.
"On the other hand," he continues, "let's say these convertibles were issued at a conversion price of $20 when the stock was $16, but the stock is now $8. So the stock will have to double to get back to $16 or so, just to get near that conversion price." That difference is referred to as the "conversion premium." The smaller the conversion premium, the better the convertible holder's chance of having large capital gains on the convertible. (See sidebar, "Under the hood with convertibles," on how convertibles work.)
Cleveland hastens to add that "obviously there are other things like whether the company is making money and paying its interest. ... But the real key is: What can the underlying common stock do and where is my conversion price? If I'm somewhere close and I think this company could really do something, then I have a super vehicle."
Beyond this, Cleveland emphasizes that convertibles investors should study the underlying company well. "What we look for," he says, "is the big three. One, is the management team good, particularly the Ceo? Does he own the stock? Do they have a record of success? Two, can the company grow above average, as much as 10?20%? And three, is the price reasonable?"
COMING INTO CONVERTIBLES
Some people avoid convertibles, preferring common stock for capital appreciation and straight bonds for income over a hybrid investment such as a convertible. Lieberman includes himself in that category. "I either want the bond or the stock, and because I do, I don't want to give up the characteristics of one or the other to take something that's neither fish nor fowl," he says. At the same time, Lieberman points out that some investors, including many conservative-minded investors, have portfolios dominated by convertibles. "They don't want to make a full-fledged bet of one type or the other," he explains. "They want the fixed-income return with the potential that, if everything works out great, they'll get an equity kicker."
Convertibles also offer investors a different way of looking at the market. Cleveland offers one example: "Let's say I want to be in oil and gas. Or I'm thinking: What is the next opportunity here in the US market? So I would get a list of maybe 25 companies and see whether any of these companies have a convertible out." In contrast to a strategy that starts with the convertible, Cleveland suggests that investors "look at the whole universe [of companies] and then see if there is a convertible I can buy to take advantage of this unique instrument."
Cleveland stresses that investing in convertibles is, in some ways, no different than investing in other securities. "It's like all investing," he says. "You've got to have a portfolio. You've got to have 10 to 20 [in order to] recover if one of your convertibles goes down." And he does recognize a growing interest in these hybrid securities. "Any time you get periods like we have now, you're going to see a lot more convertibles because everybody's scared to death and investors are saying: OGee, I've had enough Internet - I want safety. I want to have a convertible.' "
David Penn may be reached at DPenn@Traders.com.
UNDER THE HOOD WITH CONVERTIBLES
Understanding how convertibles work can be tricky. Fortunately, Charles Lieberman of Advisors Financial Center was able to provide a thorough example of how convertibles can act in the marketplace. Here is his complete explanation:
"Let's say we have a stock trading at $20 a share, and a convertible stock issued at $25 a share, convertible, share-for-share, into common stock. And the convertible pays an annual dividend of 7% or $1.75 a year.
"If the price of the stock falls from $20 to $15, the convertible may not decline very much, because the yield on the convertible will help support it. Let's say the economy goes into a recession, stock prices fall, but market interest rates fall, so that 7% yield on a convertible looks pretty attractive compared to market interest rates. And maybe the convertible falls from $25 to $24. So the decline in the stock market is cushioned, quite dramatically, by the support given by the high dividend. So that's a big plus.
"Let's say for argument's sake that one of the reasons that the stock market went down was because interest rates rose. [The Fed] tightened monetary policy in order to slow the economy down. In that case, interest rates are higher. Let's say stock prices are lower. The stock might go from $20 to $15, and the yield on Treasury bonds goes from 5% to 6.5%, in which case neither the stock price nor the dividend provides quite as much cushion to the convertible. And the convertible could fall quite sharply, too.
"Let's consider what happens in rising markets. Let's say the stock goes from $20 to $25. Now the convertible is worth at least $25, because it can be exchanged share-for-share into the common [stock]. And [if] the stock is up 25%, the convertible is also likely to go up, but less, because its value isn't being driven up by the dividend and, unlike the stock, [the convertible] has no prospect for rising dividends. [The convertible] will go up some, but substantially less than 25%. So [the convertible] participates in a rising stock market, but on a proportionately smaller basis than the common stock.
"Say the common stock goes from $20 to $40. At that point, the convertible will almost certainly be trading at $40 or slightly above $40. And obviously, the dividend yield will be a lot smaller because if you pay $40 for it but you're still getting the same dividend of $1.75, the yield is now down to less than 4.4%." -D.P.
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