Panning for Gold in "Busted Converts"

A cautious way to bet on a stock rebound

Vitesse Semiconductor (VTSS ) tops the list of beaten-down tech stocks that Ravi Malik, a money manager at Froley, Revy Investment in Los Angeles, believes will eventually rebound. The chipmaker's shares were trading at $24 recently, off from $94 in August. So is Malik snapping up Vitesse? No way, he says: "The shares may not have bottomed out yet."

Instead, Malik is making a back-door play on Vitesse by investing in its "busted" convertible bonds. All converts pay interest semiannually and can be swapped for the issuer's common shares at any time. Busted converts are those where the "conversion price"--the stock price at which it would pay for an investor to swap his bonds for stock--is at least 50% above the current share price. Because that exchange seems a remote possibility, the busted converts tend to trade at prices and yields similar to comparable nonconvertible debt. Yet if the stock rebounds, the bond could become a lot more valuable.

That's why busted converts can be a smart play. It's "a strategy for cautious optimists," says T. Anne Cox, director of global convertible research at Merrill Lynch. "It's a less risky way of betting on a fallen stock's rebound than if you bought the stock outright."

Just look at Malik's investment, the Vitesse bonds, which bear a 4% coupon and are due in 2005. The bonds trade at $761 and can be swapped for 8.9 shares of stock--an exchange ratio that was set when the bonds were issued in 2000. But making that exchange today is foolish--it's the equivalent of buying shares at $85.38, more than three times the market price. You'll only want to swap if Vitesse shares rise above the $112 conversion price--that's the point at which bond holders get $1,000, either by converting to stock or by waiting until the bond matures and pays its $1,000 face value. Until the bond matures, it pays $40 a year in interest. That works out to an annualized 11.8% yield to maturity even if the stock stays down, and perhaps a whole lot more if Malik is right and Vitesse stock takes off.

DIMMED HOPES. Thanks to the bear market, you have plenty of busted converts to choose from. In the past few years, scores of technology and telecom companies issued converts as a cheap way to raise cash. Investors snapped up these low-yielding bonds--coupons range mainly from 4% to 6%--because they believed the stock conversion features would make the bonds valuable as the tech companies soared. Things didn't work out that way. According to Merrill's Cox, busted-convertible issues make up 48% of the overall $160 billion U.S. convertible securities market vs. 22% a year ago.

Like most bonds, converts are usually issued at a par value of $1,000. But their prices tend to sag when the stock falls or when interest rates go up, even though they continue to make their semiannual payments. So even with coupons in the 4%-to-6% range, their yields are higher than that because most are selling below par. Right now, the yields to maturity on busted converts run from 7% to 16%, virtually the same as the yield on "junk," or high-yield, bonds. Nicholas Calamos, portfolio manager of Calamos High Yield Fund, notes that investors who choose convertible bonds over straight high-yield don't give up any yield to get the convertible's "equity kicker."

Investing in busted converts may be low-risk relative to buying the underlying stocks, but it's not risk-free. On average, they carry BB+ credit ratings--a notch below investment grade--and the same as the overall convertibles market. But the reason the stock prices have sunk so low is that some issuers could go belly-up. "The risk of default is real with troubled dot-coms and telecom companies," says Margaret Patel, manager of the Pioneer High Yield Fund. Consider that eToys' convertible bonds' price fell to 12 cents on the dollar in March, after the once-high-flying Web retailer filed for Chapter 11. In bankruptcy proceedings, convert holders' interests are senior to shareholders but behind those of banks and investors in regular bonds.

Since the convert market is relatively small, finding good information is tough. An excellent place to get it is the Web site It's one of the few sources open to individual investors to get daily prices and credit-quality information. The site, owned by Morgan Stanley, charges $10 a month, though it offers a free, two-week trial subscription.

In scouting for busted converts, look for companies with strong balance sheets and in businesses that still have bright prospects. Most of today's busted convertibles were issued by dot-coms, telecom outfits, and semiconductor companies. Of those three groups, the chipmakers are probably the best bet. "The semiconductor stocks have been through downturns before," says Malik, the money manager. "These are companies with real assets and real business models." Besides Vitesse Semiconductor, another chip company busted convert that Malik favors is Cymer (CYMI ), whose 7.25% bonds are due in August, 2004. Meanwhile, Merrill's Cox suggests converts issued by chip companies Analog Devices (ADI ) and TranSwitch (TXCC ) (table).

NEVER FEAR. Another factor to consider when selecting a busted convert is how much the stock needs to rise to meet its conversion price. For instance, if the stock price must triple or quadruple, ask yourself whether you'll be content to earn its yield to maturity, because the stock may never rise enough to make a swap worthwhile.

Don't be afraid of a convert whose underlying stock is volatile. If the stock has swung widely in the past, says Merrill's Cox, the odds are better that the conversion price could be reached than with a low-volatility stock. And the stock doesn't always need to reach its conversion price for the bond to trade above its $1,000 face value. That can happen as the gap between the stock and conversion prices simply narrows. For instance, if Vitesse's stock price rises to $60 instead of its $112 conversion price, figures that Vitesse's convertible bonds' price could rise to $1,102.

You can also invest in busted convertibles via mutual funds. Ironically, the 26 funds that focus on convertible securities rarely make big bets on busteds. The handful of funds that do bulk up on busteds are specialized high-yield funds such as Calamos High Yield and Pioneer High Yield. Both of these now have roughly 70% of their assets in busteds.

Without a doubt, busted convertibles are complicated instruments. But learning about them is worth the effort. After all, how many investments pay you handsomely while you're waiting for stocks to come back?

By Susan Scherreik

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