Part Stock, Part Bond: Hybrids With Yield AppealEdward Baig
You're starving for higher income but don't have the stomach to play the stock market. Those 3% rates on certificates of deposit don't offer much nourishment, and bond yields are nothing to brag about. Individuals may find an appetizing alternative in convertible preferred stocks, hybrid securities with characteristics of both stocks and bonds.
Convertible preferreds can be exchanged any time for a fixed number of common shares in the same company. The appeal: Preferreds provide superior yields and a better credit standing than ordinary stocks, yet the convertible feature offers the chance to profit if the underlying commons appreciate. Through the first three quarters of 1993, according to Kidder Peabody, total returns on newly issued convertible preferred stocks have outpaced their underlying commons 16.02% to 12.76%.
LONG HAUL. Convertible preferreds are usually less risky than ordinary shares, though they'll return less when a stock takes off than if you had bought common shares to begin with. "A typical convertible will give you 66% to 75% of the upside appreciation of a common stock but only 33% to 35% on the downside," says Richard Ng-Yow, a convertible-securities analyst at Kidder Peabody.
He favors Ford Motor's convertible preferreds, which boast a 4% dividend yield, vs. 2.6% for Ford's common. The yield is especially attractive given that the premium you pay for the convertible is just 4% above the common-stock value. While the common was trading recently at 611 2, the convertible preferred was at 104, and each convertible share could be exchanged for 1.63 common shares.
Ng-Yow recommends convertibles that have a breakeven point--the time it takes for the convertible's current yield advantage to recoup the premium--of three to four years. Since the issuing company can call a convertible for redemption--usually after the common stock appreciates--investors who want to enjoy higher yields over the long haul should seek call-protection provisions of three years or more. Ford's convertibles can't be called until Dec. 7, 1997; Delta Air Lines' can't be called before June 24, 1995, and then only if the common stock, now 60, has reached 821 8.
The hybrids do carry risks. Convertible preferreds are sometimes issued in distressed situations to raise capital when the stock price is depressed, says John Wylie, a portfolio manager at Nicholas-Applegate Capital Management. So investors need to scrutinize company fundamentals as they would with any stock. Also, most preferred dividends are fixed. A rise in the common dividend could wipe some shine off your investment, since you paid for a yield advantage that no longer exists.
A PREFERRED SAMPLING Issue Price Yield Conversion Nov. 8, 1993 premium BANK AMERICA $58.25 5.6% 27% COOPER INDUSTRIES 31.63 5.1 8 DELTA AIR LINES 57.50 6.1 26 FORD MOTOR 104.13 4.0 4 GME 56.50 5.8 33 DATA: KIDDER, PEABODY & CO.
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