If you'd like to buy shares of a certain company, but its lofty stock price makes you nervous, see if a convertible is available. Since these securities (most often bonds but sometimes preferred stocks) can be exchanged for a set number of common shares, their prices tend to track their companion stock on the way up. But because they pay coupons higher than the stock dividends, they don't fall as far in a downturn. The result: "You get nearly the same returns as the stock at less risk," says John Calamos, president of Calamos Asset Management in Naperville, Ill.
Convertibles are a particularly good value right now. Like all fixed-income investments, they got hammered last year when interest rates were rising. A lot of forced selling took place as managers liquidated holdings to cover leveraged positions. "That's why we feel this is an extraordinary time for someone to get into the convertible market," says Warren Bree, president of Wolverine Asset Management in New York.
CONVERSION COSTS. The main way to assess a convertible is to look at the "conversion premium." This is the difference between the common stock price and the price at which the convertible can be exchanged for stock. Convertibles nearly always trade at a premium, since you get the added benefits of higher yield, seniority in a bankruptcy, and the conversion option. But because you pay a premium, it rarely pays to convert the bond.
Right now, conversion premiums are the lowest they've been in years. At the end of 1993, new-issue convertibles typically carried a 25% premium. Now, you can find excellent ones, such as Barnett Banks or Ford Motor, trading at a 10% premium or less, Bree says. If the premium is low, the convertible tracks the stock much more closely, so on a bond with a 15% premium, you could figure on getting 85% of a stock's positive return. If the convertible isn't selling for much more than a similar corporate bond, you could be subject to only a fraction of the stock's decline.
If getting most of the upside and a lot less of the downside appeals to you, your best bet is to choose a diversified portfolio of convertibles through a mutual fund or money manager. This frees you from having to evaluate convertibles yourself. Top-performing funds for the past five years include MainStay Convertible (17.18% average annual return), Bond Fund for Growth (15.25%), and Fidelity Convertible Securities (15.02%). Check if the fund emphasizes current income or capital appreciation and review credit quality to find one that meets your risk tolerance.
Another way into the convertible market is to find a stock you like and then check out its convertible. "You never buy the convertible if you wouldn't buy the common stock," Bree says. To determine whether a convertible is a good deal, many investors compare the conversion premium to the difference between the convertible's yield and the stock dividend. If there is a 7%-a-year yield advantage to owning the, convertible, and you plan to hold it for three years, a 21% premium may be justified, says Mitchell Cone, assistant manager of Franklin Convertible Securities. "You also have to check what downside protection you're getting," says Cone. To do this, see how the yield stacks up against that of similar quality paper. A convertible's yield will not climb past that level, no matter how far the stock declines. Also check the call provisions: If a convertible is called early, you may not recover the premium you paid.
VALUES. Compare convertibles to other issues in the same industry. Cone is finding good values now in convertible real estate investment trusts, such as Liberty Property Trust, as well as oil-and-gas issues such as Parker & Parsley Petroleum. Bree likes some regional banks, and Calamos likes the battered automotive and financial sectors.
If you later grow so fond of the company that you want to own the stock, you should probably sell the convertible and purchase shares, despite the cost of commissions, says Ted Everett, assistant portfolio manager of Bond Fund for Growth. You should only convert the bond if the company calls it at a price way below its market price or if the dividends on the stock are higher than on the convertible--although that's a rarity. Right now, convertibles are so attractive, conservative investors may never want to go back to owning the stock.