Convertible securities are hybrid investment instruments that are made up of one part bond and one part warrant (a call option on the underlying common stock or some other interest). The conversion feature inherent in these types of securities allows them to participate in the appreciation of the underlying common stock, thus providing the potential for capital gains. When the underlying common stocks rise, convertibles typically climb with them, although at a slower pace. But when the stocks fall, convertibles fall substantially less because of the underlying bond attributes. What attracts most investors to convertibles, however, is the return potential relative to risk.
One of the many advantages investors who buy convertibles have is the ability to adjust their portfolios to reflect their view of the market. In times of greater-than-normal uncertainty, for example, a portfolio of convertibles can be tailored so that it has virtually no exposure to downturns in common stock prices, yet provides relatively high yields, with the potential to share in the underlying stocks if they rise significantly. Busted convertibles (those trading near or on their investment value) are the best examples of this. They offer minimal participation in the upside of the underlying common stock, but provide solid downside protection. If the stocks rocket higher, however, the conversion feature could eventually become an added bonus.
Interest income or dividend payments from a convertible security provide a steady stream of income. Generally, a convertible will have a greater yield than its underlying common. As of our October 15, 2010 pricing date, the average convertible yielded 3.9%, while the average common stock underlying these convertibles yielded about 0.9%.
The bond-like portion of the convertible will have a "present" or "investment" value below which the convertible should not trade, unless a downgrade in investment quality is perceived by the investing public. And even then, the value of the convertible usually will fall to a new lower level, not become worthless. Be aware, however, that the investment value is contingent on prevailing interest rates and the financial position of the issuing company, among other variables.
The risk inherent in a convertible is expressed as Relative Volatility in our Service. Invariably, because of its defensive nature, income stream, and preference over the common, the typical convertible will have lower risk than the underlying common stock. Convertible preferred stocks tend to be somewhat more volatile than convertible bonds, but less risky than common stock because the average convertible preferred stock has the tendency to trade at a lower premium over conversion value and will track more closely the movements of the common.
If you wish to minimize your exposure to high volatility (as being experienced in the equity markets these days), then invest in convertibles with high premiums over conversion value. These convertibles are relatively immune to declines in their underlying stocks, but they tend to have a high sensitivity to changes in interest rates and their appreciation potential is generally limited. The more attractive convertibles, in terms of risk, yield, and appreciation potential, are shown on our Especially Recommended list.