Convertible Bonds: Opportunity Knocks

Investors who disdain sitting on cash as the market meanders are again buying convertible bonds, firing up the market for hybrid new issues

By David Bogoslaw

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%.

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