Opinion: Revved-up convertibles worth a look

He walked into my office, donut and wrapper in one hand and a cup of McDonald’s coffee in the other, and mumbled, “I’m thinking about convertibles.”

So I asked him if he had researched convertibles and whether he knew all the pros and cons.

“Yep, I’ve been on the Internet and checked them out.”

“So how many are you going to buy?”

“Well, just one. I don’t know why I would need more than one.”

That led me to start a dissertation on the merits and risks of convertibles, but I didn’t get very far. As I began talking about premiums and discounts and busted converts, he interrupted.

“Man, you are on a different page. I am talking about maybe buying a Sebring or Mustang convertible.”

“Oh.” We were on different pages. It pays to make sure to know what a person is talking about before jumping to an answer, something I hadn’t done. “Sorry that I misunderstood.”

Jimmy’s curiosity was set in motion. He said that he was leaning toward the Sebring, but since I brought up the subject of convertibles, were they something he should be investing in?

Which led to my brief discourse, the gist of which was this:

Convertibles may be bonds or preferred stocks that offer the holder the option to convert them into common stock, generally for a set period of time. We focused on bonds. Some investors think of them as the best of both worlds, a bond that pays interest combined with the potential for gains should the underlying stock appreciate in value.

However, there are trade-offs. The interest rates on convertibles are normally less than the rates on nonconvertible bonds but higher than the dividend yield paid on the company’s stock, and the credit ratings (a measurement of risk) are lower.

And converts (the jargon used by Wall Street) are issued at a premium to the value of the stocks into which they are convertible, normally in the range of 25 percent to 30 percent. Here’s an example: XYZ Corp. issues a $1,000 face-amount convertible bond that pays an interest rate of 5 percent, matures in 10 years, and is convertible into 20 shares of common stock. At the time the bond is issued, the common stock is trading at $40 – thus the value at conversion (20 shares times $40) is $800. The $200 difference is the premium of 25 percent. It is the cost to the investor of having the right to convert.

On the other end of the spectrum is the busted convert, a situation that occurs when the price of the common stock is so far below the conversion value that the bond trades as though there is little likelihood of it being converted. In this case, the bond will trade to yield a rate similar to nonconvertible bonds. Some consider that a price 50 percent below conversion value defines a “busted” convert. There are those who invest in such issues, but that is best left to the professionals. (Do not try this at home.)

For the individual investor who wants to participate in the convertible bond arena, we suggest specialized mutual funds, especially closed-end funds, leaving the analysis and transaction decisions to the experts and providing good diversification. Among the funds we use for our clients are the Calamos Convertible Opportunities and Income Fund (NYSE: CHI) and the Calamos Convertible and High Income Fund (NYSE: CHY).

Don’t just rush out and buy these funds. They can trade at substantial premiums to their net asset value, a fact that should be considered. Check with your financial professional to see if they are appropriate for your risk tolerance. If they are, you may have the opportunity to participate in the best of both worlds.

*Note: Jimmy the Oracle doesn’t actually exist: he’s a blend of client experiences all rolled into one lovable repository of whatever attributes I care to give him. He’s akin to the imaginary friend my daughter had as a child. Jimmy is a great source of column ideas.

Clark Davis is a 37-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money-management company. He can be reached at cdavis@slia.com.