What's Comfy About Convertible Bonds

They're preferred shares an investor can choose to convert into a stock, and they offer both income and a possible equity kicker
Illustration by Stefanie Augustine

They're not quite bonds, despite making regular payments. Nor are they exactly stocks, though their value fluctuates with a company's share price. They're convertibles—hybrid securities that throw off steady income but can be converted into stock. For fence-sitters torn between wanting stable income and not wanting to miss out on a stock market rally, they're a way to keep your options open.

Right now the market's flooded with convertibles. Led by the financial sector, companies issued $35.2 billion worth in the second quarter, up 18.5% from the same period in 2007 and more than double the number issued during the first quarter of 2008.

Companies like convertibles, which can be bonds or preferred shares, because they're a low-cost source of capital that doesn't do nasty things to a balance sheet. If a company issued shares when its stock traded near 10-year lows, current shareholders would see the value of their shares cut to a fraction of their current worth. And a debt issue could spark a credit-rating downgrade. But rating agencies treat some convertibles as equity—no downgrade worries there. Also, since the set price at which investors can convert is 15% to 25% higher than a stock's price when the security is bought, many bonds may not convert. Because of the option to convert into stock, companies are able borrow at a reduced rate—as much as two to three percentage points less than if they had issued regular debt.

For investors, convertible bonds offer income and a possible equity kicker. If the company's stock rallies and you're bullish, you can convert to stock once you hit the conversion price. If the market tanks, you still get your income—and your investment back when the bond matures. What you've given up for the option to convert is a few more percentage points in income that you could have had with a regular bond.

Sorting through individual convertible issues is tough, though, and investors may not want to commit the $200,000 or more advisers say is needed to buy a diversified portfolio. Also, the market for trading the securities isn't very liquid. An easier way in is through a mutual fund. Morningstar (MORN) lists 21 convertible funds, with one new offering, Miller Convertible Fund, launched at the start of the year. The average fund is down 8.4% in 2008, roughly half the Standard & Poor's (MHP) 500-stock index's dive. Individual fund performance ranges from Miller Convertible's -5.5% to Dunham Appreciation & Income's S&P-like 13.1% drop.

Convertible funds have different philosophies about risk. One distinction is how much they own in convertible bonds or in a riskier type of hybrid—convertible preferred shares. These are equities that, in exchange for not conferring voting rights, pay a fixed dividend. In case of a bankruptcy, preferreds are senior to common stock. They have no maturity date, and the way investors get out is by selling shares. So if the stock is down, they take a loss. The shares pay about two percentage points more than a comparable convertible bond.

Since convertible bonds are safer than preferreds, the higher the ratio of preferreds to bonds, the riskier the portfolio. Miller Convertible Fund owns just one preferred, a Bank of America (BAC) issue. Otherwise, manager Greg Miller sticks almost entirely to bonds. His goal is absolute returns—fundspeak for not losing money—and while the value of convertible bonds may fluctuate over time, if they're held to maturity, they return all an investor's cash.

Funds also differ in whether they own common stock. In some cases a convertible was redeemed for stock and the manager liked it enough not to sell. But some, like Larry Keele, sub-adviser to Vanguard Convertible Securities Fund, avoid stocks completely.

Then there are a fund's holdings of financial convertibles. Most managers are leery of big stakes, but few avoid them completely. Miller Fund owns one—that Bank of America preferred. Morgan Stanley Convertible Securities Trust has mostly tech, health, and energy, with 10% in financials.

Other managers see more opportunity. Many financial convertibles pay high yields and have seemingly limited downside, since the stocks have fallen so far. Edward Silverstein, manager of MainStay Convertible Fund, has 15% in financials, including Citigroup (C), Bank of America, and Merrill Lynch (MER). But for a truly contrarian pick, look at the portfolio of David King, manager of Putnam Convertible Income-Growth Trust. Despite the problems facing mortgage insurers, he likes a MGIC Investment convertible bond, which has a 9% coupon. The bond is trading at around 70 cents on the dollar, however, giving it a current yield of about 13%.

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