Following some stormy times, it may be convertible weather once again.
Convertible securities, that is. Not ragtop automobiles.
These are preferred stocks or bonds that may be converted into a specified number of a company's common shares at a set price. Convertibles traditionally offer the high yields and defensive personality of bonds, with the upside potential of stocks.
A barrage of bad news for these hybrid securities came this year in the form of higher interest rates, lower stock prices and heavy selling by big investors. This abruptly halted three years of gains.
"The convertible market got a bit euphoric and pricey late last year and was ready for a decline," explained F. Barry Nelson, editor of the New York-based Value Line Convertibles newsletter.
The sunny side of the resulting decline is that the $100 billion convertible market became inexpensive and attractive for individual investors.
"Convertibles are underloved, under-researched and undervalued," said Michael Rosen, portfolio manager of the Bond Fund for Growth, a $108 million convertible fund in Rochester, N.Y., with a one-year total return of 12 percent. "But they're attractive for the issuer and purchaser."
If a company issuing a convertible prospers and the market value of its stock goes up, the investor has an
opportunity to share in the good fortune by converting to the company's common stock. Conversion is always at the investor's option, and done only when the common stock's market value and dividends are high enough to make the conversion profitable to the investor.
"As investors became more comfortable with a variety of investments such as options and warrants, it was a natural extension to become more comfortable with convertibles," explained Anne Cox, vice president for convertible research at Merrill Lynch & Co., who says they're best for conservative folks seeking some income and risk-adjusted return.
Though the average convertible bond has a maturity of 9 to 9 1/2 years, the convertible preferred is an equity investment with no maturity date at which principal is returned. Less secure than the convertible bond, the preferred nonetheless provides more income.
While convertibles don't rise as much as the issuing company's common stock in a bull market, they usually don't fall as much as the common stock in a dropping market because the yield provides cushion. The "premium" of a convertible measures the percentage by which its price is greater than its underlying equities. "When you've had a correction, coming off high valuations, it's a good time to be buying convertibles," said Fred Gifford, vice president with Calamos Asset Management Inc., which manages pension assets for large corporations. "Convertible yields are up, averaging about 6.7 percent, but prices have come down."
Convertibles usually have a provision that gives the issuing firm a chance to call in the convertible at a specified price and pay it off, but it will never sell below its conversion value. Quality is improving. Forty percent of the U.S. convertible securities market is now investment grade, compared with primarily small-capitalization or low-quality issuers a few years ago.
Besides mutual funds investing in convertibles, there are individual securities that merit attention.
The Time Warner Inc. 8.75 percent convertible bond due Jan. 10, 2015, is recommended by both Rosen and Gifford.
Another Rosen selection is Bell Sports 4.25 percent convertible bond due Nov. 15, 2000, along with Fisher Scientific 4.75 convertible bond due March 1, 2003; and Rochester Community Savings Bank $1.75 convertible preferred.
The Quantum Corp. 6.375 percent convertible bond due April 1, 2002, is a Nelson selection.
Other picks are National Semiconductor $3.25 convertible preferred and National Education 6.50 percent convertible bond due May 15, 2011.
The Browning-Ferris 6.75 percent convertible bond due July 18, 2005, is favored by Cox. Noble Affiliates 4.25 percent convertible bond due Nov. 1, 2003; Magma Copper 5.85 percent convertible preferred; and BankAmerica Corp. 6.50 percent convertible preferred are additional Cox choices.
The Motorola Inc. zero-coupon convertible preferred due Sept. 27, 2013, is a Gifford recommendation, as well as Republic New York Corp. 3.375 percent convertible preferred and Snyder Oil Corp. 7 percent convertible bond due May 15, 2001.