Investing

Convertible Bonds: Opportunity Knocks


Until its Mar. 30 sell-off, the stock market seemed to have turned a corner. The Standard & Poor's index of 500 stocks had bounced more than 20% within three weeks of its 12-year low. But the market's big move lower—and its subsequent snap back on Mar. 31—serve only to remind investors how volatile the equity environment remains. The direction of the market again looks to be anyone's guess.

The conventional thinking in an unpredictable market like this is to keep your portfolio mostly in cash until you're sure of a sustainable trend. Rather than agonizing over market bottoms and how to time reentry into stocks, why not get paid to wait for something good to happen? That's what you're doing when you buy convertible bonds, says John Calamos, chief executive and chief investment officer of Calamos Investments (CLMS) in Naperville, Ill. Convertibles are a hybrid security that offers the downside protection of a bond along with the potential to capture 60% to 70% of the upside movement in the underlying stock.

Calamos says he's increased the allocation to convertibles in his Growth & Income Fund based on how undervalued they are. "Even with a market going sideways here, if convertibles went to their normal price, they would be up 8% or 9%—plus their current yield—where the stock market would be flat," he says.

Calamos believes that the technology, health-care, and industrials sectors warrant an overweight allocation in an investor's portfolio right now. His funds are also holding some financial companies that issue convertible preferred shares instead of bonds, "but we feel we're walking on eggshells," he says. "Given the choice, you'd rather have a convertible bond to a convertible preferred. Usually your dividend is secured before the common dividend, and you're higher in the capital structure than common stock."

lower interest and a premium price

From a company's perspective, convertibles are a way to raise money for working capital needs, new investments, or refinancing existing debt while saving a lot in annual interest payments. Newell Rubbermaid (NWL) is a good example. On Mar. 25, the company, which has a credit rating of BBB-, issued $345 million in convertible senior notes due 2014, paying a 5.5% coupon and priced with a 30% conversion premium. Compare that to a traditional bond Newell issued previously that matures in 2013 and that currently has a yield to maturity above 10%.

"They're literally reducing their interest payment by 4.5% and able to sell their stock at a 30% premium," says Steve Kloude, senior strategy analyst at Calamos.

The convertibles market collapsed last September after Lehman Brothers filed for bankruptcy protection. That forced over-leveraged hedge funds that had taken long bets on convertible bonds, offset by short bets on the corresponding stocks, to sell their convertibles holdings in order to fund a deluge of redemption requests from investors. On top of that, a temporary ban on short selling by the Securities & Exchange Commission also disrupted their strategy: Since they could no longer hedge by shorting the stocks, hedge funds couldn't continue to buy convertibles.

The enormous sell-off made 2008 the worst year on record for convertible returns. But at least some fund managers saw the historically cheap bond prices as an opportunity, recognizing that the prices didn't reflect higher risk of default by the issuers. Calamos reopened his closed-end convertibles fund after a four-year hiatus. Larry Keele, sub-advisor of the Vanguard Convertible Securities Fund (VCVSX) managed by Oaktree Capital Management, began to buy investment-grade names with very short-dated maturities and yields to maturity of at least 10%.

oversubscribed convertibles issues

It took two months, but by the end of November the convertibles market had turned positive on a wave of bargain buying, which included companies buying back their own issues at deep discounts, paying as little as 60¢ to 80¢ on the dollar, says Keele at Oaktree. Strong demand for the securities has kept up since then, with convertibles outperforming stocks by a wide margin so far this year, he adds.

After an extended lull, new issues have begun to make a comeback, too. In addition to Newell, Johnson Controls (JCI) and Alcoa (AA) had convertibles offerings in March that were oversubscribed. Alcoa's bonds were trading 30% above par in the secondary market a week after being issued and Newell's were at 110% within three days on the market, says Keele.

The market for new issues can grow very quickly, says Venu Krishna, head of equity-linked strategies at Barclays Capital (BCS) in New York. With $3 billion of convertibles already issued this year, there's enough demand and capacity from institutional investors to easily absorb at least an additional $60 billion this year at minimum, he says. In 2008 the market absorbed $62 billion of new issuance from January through the first week of September.

So how should an investor assess the value proposition of a convertible bond? There are two basic metrics to look at: the coupon, or interest rate, the bond is paying, and the conversion premium—or how much higher than the current stock price it needs to trade in order for you to exercise your option of converting it into common shares.

"new issue coupons are higher"

On average, new issues in 2008 were 3.5% below fair market value at issuance. The new issues that have come to the market thus far in 2009 are roughly 4.8% under fair market value, suggesting good value for investors, says Krishna at Barclays. Most of the new issues are trading well above par already in the secondary market, an indication of strong demand and reasonable valuation, he adds. Overall valuations in the convert market valuations remain attractive, both from an absolute and relative value standpoint.

"New issue coupons are higher. Weighted average yield is 6.5% and the weighted [conversion] premiums are 22.5%, which is very reasonable," Krishna says.

Generally speaking, any new issue with a low coupon and a conversion premium above 40% is considered expensive but there are exceptions, such as marquee-name companies whose stocks have taken a beating but are still regarded as good credit risks, says Krishna. The higher the conversion premium, the more out-of-the-money the option is, which translates to less initial equity upside should the stock gain in price.

You typically buy a convertible looking for the upside in the stock because that pulls the value of the bond up with it. But the strategy works better the more balance you maintain between the upside potential and the downside risk, fund managers say. They generally advise selling a convertible once it reaches 140% to 160% of par value and buying another convertible trading closer to par—either in the same company, if possible, or another one.

Fine tune your risk/reward profile

The farther above par the security trades, the more closely it tracks the underlying stock. And the more sensitive it becomes to the stock price, the more downside risk it has compared to when it was at par, says Kloude at Calamos.

"You need to be constantly readjusting your risk/reward profile," he says.

Not all convertibles are bets on the upside potential of the underlying stock. More conservative investors may buy them almost entirely for their bond-like qualities—the assurance of recouping their principal plus interest. The Greenspring Fund (GRSPX) invests only in "busted convertibles"—securities whose underlying stocks are trading so far below the conversion price that there's essentially no chance of their reaching that level.

"We tend to keep our maturities short," typically 9 to 15 months, says Michael Fusting, co-chief investment officer at Lutherville (Md.)-based Corbyn Investment Management, advisor to the $313 million Greenspring Fund. "We don't want to take interest-rate risk."

stocks lack a "defined exit point"

The Greenspring portfolio had a 29% allocation to stocks at the end of February, but Fusting likes a fixed income portfolio for its defined exit strategy—the maturity date. "If you do your homework right, if you're buying at a 10% yield to maturity, when the maturity comes along, you've actually earned that yield to maturity," he says.

In contrast, since there's no defined exit point for stocks, you always have to find someone willing to pay for them if you want to get out of your position, he adds.

The current market environment has lots of investors swearing off stocks until further notice, an argument Calamos rejects. "You need to manage through those periods [of higher risk] as best you can, so using a defensive strategy makes a lot of sense," he says.

And for investors, some smartly chosen convertibles may be just the thing until the dust settles in the stock market.

Bogoslaw is a reporter for BusinessWeek's Investing channel.

Bogoslaw is a reporter for Bloomberg Businessweek's Finance channel.

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