Almost all convertibles are issued at a lower coupon rate than a similar instrument without the conversion feature. The conversion feature is the trade-off for the lower rate; holders get to participate in the activities of the stock. Invariably, almost every convertible comes to market at a higher yield than its underlying common stock, except in cases of zero-coupon convertibles and convertibles offered by Real Estate Investment Trusts (REITs).
A convertible’s higher income is a major draw for many investors. The added income helps protect the convertible against potential declines in the price of its underlying common stock, and contributes to the attractive total returns that convertibles provide over time. As of our May 14, 2010 pricing date, convertibles yielded 3.8%, on average, while their underlying common stocks averaged about 1.0%. The median yield for all dividend-paying stocks followed by The Value Investment Survey was 1.9%.
The yield spread between a convertible and its underlying common stock is generally widest when the convertible is issued. While the added income helps to offset the convertible’s lack of full participation in the stock, it also aids in the recovery of the premium investors paid at issuance. Generally, a convertible’s income stream is fixed until maturity where bonds are concerned, and perpetual in the case of preferred stocks. But dividends on the underlying common stock can change and, over time, could surpass income from the convertible, if the convertible price is high enough to cause that effect. However, bear in mind that when a company is under financial strain, typically, the first thing to be eliminated is the common stock dividend. But the last thing a corporation wants to do is default on its debt because holders of the debt can take some control of the company.
The wider the yield spread between the common and the convertible, the more attractive the convertible will be to an investor. However, there are other advantages in buying a convertible over the underlying common. The convertible is a safer investment because of its less volatile nature, and ranks ahead of the common stock in the company’s hierarchy- if the company has to be dissolved. Also, most convertibles are issued with call protection that lasts for up to five years; a period within which the company cannot recall the debt, until certain stipulations set out in the indenture that governs the terms of the convertible are met. Such stipulations may include the common stock price being at a preset level for a number of days, and/or the common price being a certain percentage above the conversion price during a certain period of time.
By investing in convertibles, buyers accept a trade-off. The lower rate of interest is swapped for the participation in the activities of the underlying common stock. The yield advantage acts as a cushion should there be a decline in the stock, and helps to recover the extra money paid for the convertible at issuance. So, unless an investor truly wants to own the stock of the company with outstanding convertible debt, it may be to his/her advantage to invest in the convertible as long as the yield advantage is suitable.