11/16/98 BARGAIN TIME FOR CONVERTIBLE BONDS

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BARGAIN TIME FOR CONVERTIBLE BONDS

If the recent stock slide made you want to run for cover, but low bond yields left you uninspired, perhaps you should consider convertible securities. Bonds or preferred shares that can be turned into common stock, convertibles allow investors to profit when stocks rise but offer the protection of fat yields when equities fall. Attractive in a volatile market, they are even more so at today's prices. ''There are some extremely good buys out there,'' says Nick Cala-mos, director of research at Calamos Asset Management, whose convertible funds are among the year's best performers (table).
A company's convertibles tend to rise along with its common stock price--typically two-thirds as much, according to Merrill Lynch. But when stocks sag, the average convertible suffers only half the damage. That risk-reward profile may reassure nervous investors intrigued by the nascent rally in small-company stocks. With two-thirds of all convertibles issued by small and midsize companies, these hybrids offer exposure to the volatile market at a fraction of the risk.
HEDGE HASSLE. A word of warning, though: Convertibles don't always deliver as much protection as expected. In August, if the normal pattern had prevailed, convertibles would have lost half the 19.3% forfeited by their parent companies' stocks. Instead, Merrill estimates they tumbled 11.5%. Already punished when investors unloaded the stocks to which they are tethered, convertibles fell even more when cash-strapped hedge funds sold them indiscriminately, notes Sandra Durn, manager of the Nicholas-Applegate Convertible fund. As a result, Merrill calculates that convertibles now trade at 4% below their fair value, more than twice the normal discount.
Ordinarily, it is hard to discern bargains in the complex convertible market. But with prices low and yields higher than usual, some instances of mispricing have become easier to spot. For example, some convertibles are yielding more than comparable regular bonds, the opposite of what's typically true. As a result, investors are getting the convertible's extra feature--its option to be exchanged for stock--for free.
Consider Thermo Electron, a $3.6 billion maker of recycling and biomedical products, which starts companies around the technologies it develops. Its convertible yields 7.8%, while its straight bond returns 7.66%. Another with cheap convertibles is HealthSouth, a network of outpatient surgery and rehabilitation centers.Its convertible and bond bothyield about8%, Calamos says. Both convertibles are sold over the counter in $1,000 denominations.
The companies' stocks and convertibles were hit hard for reasons separate from global credit jitters. Thermo Electron fell short of earnings expectations, and HMOs are pressuring HealthSouth to cut costs. But Calamos maintains that both convertibles were punished excessively: ''With pressure on hedge funds to sell, convertibles are being pushed down in price by 3%, 5%, even 10% more than where they would be.''
Still, neophytes should be careful about buying based on a simple yield comparison. When a company is in dire straits, its convertible sometimes returns more than its bonds because convertible holders are at greater risk of getting stiffed in a bankruptcy, says Merrill First Vice-President Anne Cox. Convertibles also could be thrashed should concerns about recession or emerging markets resurface.
Given the $120 billion convertible market's complexities, experts advise individuals to approach it through one of 27 open-end and nine closed-end convertible funds. Funds have the resources to construct diversified portfolios of the bonds, which usually trade in large blocks in the over-the-counter market.
In selecting a convertible fund, you should consider more than fees and performance. It's important to know whether a manager invests in other securities, says Jon Hale, analyst for Morningstar. When stocks were soaring, some top convertible funds juiced up returns by putting as much as 25% of their assets into stocks. There's nothing wrong with that unless you want a more defensive investment. You can check out a convertible fund's common stock holdings at several investor Web sites, including www.cbsmarketwatch.com and www.personalwealth.com.
One way to size up how much protection a fund is likely to offer is to look at its average premium. Because convertibles pay higher dividends than common stock, investors must pay a premium over the price of the common to purchase them. Convertibles with higher premiums than today's 39% average are better insulated from stock price swings. By contrast, those with low premiums tend to more closely track their corresponding shares. Which makes sense depends on how conservative you want to be. If income is a priority, funds with high premiums carry the best yields.
If you want to go it alone, how can you pick a good convertible bond? Find a company whose prospects you like. ''The primary driver of convertible performance is the underlying stock,'' says Charles Pohl, senior portfolio manager of the Putnam Convertible Income-Growth Trust. Then comes the old standby, the breakeven analysis.
Consider Rite Aid's 5.25% convertible bond, maturing in 2002. To calcalculate its premium, multiply the drugstore chain's $39 stock price by the 27.672 shares its convertible can be redeemed for. The result, the convertible's value today, is $1,079. The difference between that sum and the convertible's actual price of $1,260 is the ''conversion premium'' of $181, or 17%.
To figure out how long it will take to recoup the extra $181 the convertible costs, divide the 17% premium by the 4.15-point difference between the convertible's 5.25% yield and the stock's 1.1% yield. In Rite Aid's case, the investor breaks even after four years. But because the chain can call the bond or force a conversion in two years, an investor will lose money unless the convertible rises by more than $181 first.
SAFE BET? Nicholas-Applegate's Durn believes Rite Aid's stock will rise enough to make the convertible a safe bet. But her analysis defies a do-it-yourself approach. Before buying, she plugs prospects into a model that weighs interest-rate spreads, stock price volatility, and the company's credit profile, among other factors. Her goal: to find convertibles like Rite Aid's that are likely to participate in 60% to 80% of a stock's rise, but 50% or less of its fall.
To get data for a breakeven analysis, you can find convertible bond quotes in newspapers, on the Web (one source is www.convertbond.com), or in Value Line's Convertibles Survey, available at public libraries. For help crunching the numbers, try a Web calculator. You can find a good one at www.numa.com/derivs/ref/calculat/cb/calc-cba.htm). If your goal is to remain exposed to stocks, but you're afraid of the market's gyrations, convertibles may be an acceptable middle ground. At today's bargain prices, they're an especially appealing alternative.
By Anne Tergesen
EDITED BY AMY DUNKIN

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