Convertibles: best of 2 worlds - to a point
People don't seem to be getting much out of their stocks these days. Prices certainly aren't providing much of a reward, and many companies have reduced their dividends. Some of these investors, including many who are near or in retirement, are putting part of their money into a hybrid of stocks and bonds called convertible bonds. When stocks are stingy with their dividends, convertible bonds provide a steady income stream without the risk of stocks but with the potential for a some gain if the stock does start up again.
Lately, however, even convertibles have had to become more attractive to pull in investors.
``There are more bonds out there than we've ever seen,'' says Thomas Noddings, president of Noddings & Associates Inc., a broker in Oak Brook, Ill. More corporations are issuing convertible bonds than in the past, Mr. Noddings says, and ``there are a lot of new convertible-bond managers in the game. There are some inexperienced money managers selling these things.''
One problem is the way convertibles are sold. Because they offer the steady income of a bond and the potential price appreciation of stocks, convertibles are often touted as offering the best of both worlds. But like the musician who tries to play two instruments and ends up playing neither one too well, convertible bonds fall a little short of both bonds and stocks.
They don't pay as high a yield as bonds and, when the stock moves up again, they don't rise as fast. At some point, however, you can convert your bond into shares of stock and share fully in the company's good times. This is where convertibles get their name.
Convertibles used to be issued almost exclusively by small companies that would otherwise have had trouble attracting investors. In recent years, some of the major corporations have started issuing convertibles, too, because they are a relatively cheap way to raise cash.
At any given time, Noddings says, about a quarter of the companies on the New York and American Stock Exchanges and the over-the-counter market will have convertible bonds available. ``This is a broader market than I've ever seen,'' he says.
If the bonds are issued by companies on the New York exchange, they will be listed in the bond tables of the Wall Street Journal.
``Companies can borrow more cheaply with convertibles,'' says Russell Newton, a vice-president at Prescott, Ball & Turben Inc., a brokerage. While a company would have to offer 9 to 10 percent yields on standard corporate bonds, Mr. Newton says, it may have to pay only 6 or 7 percent on convertibles. At the same time, the company brings in new investors without diluting existing shares.
``Eventually the bonds will be converted to stock, so there will be some dilution,'' Newton says. ``But it will be done gradually, not all at once like you'd get with a new stock issue.''
Also, while having the bonds converted to shares of stock does cause some dilution, the company doesn't have to come up with the money to pay back the principal on the bonds. Because convertibles are a fairly conservative investment, they are often recommended for people who are retired or who expect to retire in a few years.
``The risk is not as great, even though convertibles got beat up like everything else in the [October] crash,'' Newton says. ``But if a company is paying 7 percent on its convertible, it will keep paying 7 percent even when it may be paying a tiny dividend or nothing on its stock.
But just because convertibles are more conservative than stocks or bonds, that doesn't mean all the risk is eliminated. People who want a steady stream of income from a security that doesn't change in value shouldn't expect this from convertibles. ``They're still volatile,'' Newton says. ``Nobody should think they aren't.''
In selecting a convertible, it's important to calculate the break-even period. This will tell you how long it will take for the convertible's higher interest income - compared with the stock's dividend - to earn back its premium. The premium represents the additional cost of the bond over what you get when it is converted into stock.
The premiums can vary from a few percentage points over the conversion price to more than 25 percent. If the premium is high, the stock is going to have to rise that much more for investors to break even. This is where you figure out the break-even period.
Although convertibles can be bought through discount brokers, the commissions on them are fairly low - $4 to $20 per bond, depending on the broker and size of the order - so most investors will probably want to use a full-service broker, or a money manager with experience in convertibles, to help figure out break-even periods, conversion values, and bond ratings.