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In an economic environment where stocks are advancing, investors turn to stocks because of quick returns. However, volatility plays a vital part in how long these gains can be sustained. When there is a downturn in the equity markets, like we have been experiencing, investors seek to find safer investments such as bonds and other more stable instruments. Indeed, the diversity and hedge capabilities of convertibles offer investors a veritable plethora of opportunities to tailor a portfolio to meet their specific goals. Still, many investors do not include convertibles to their portfolios fearing the intricacies of convertible securities are beyond their level of market sophistication. Nevertheless, the basic principles and terms of convertibles are as easy to understand as the key concepts of “straight” (non-convertible) bonds and stocks. Even the more advanced concepts of convertible trading can easily be learned. To be sure, some of the concepts we outline in this article may seem complicated, and in most cases, a basic understanding is all that’s necessary as our model calculates and determines many of these values for each convertible in our survey.

Because convertibles are hybrid instruments—part fixed income and part warrant on the underlying stock—it is very common for analysts to have different opinions on the price of a particular convertible. The value assigned to the bond portion plus the value of the conversion feature together form the fair value for the convertible, and that value is then used as a benchmark by our model to determine if convertible is over- or undervalued. The two main factors used in evaluating a convertible, however, are the issue’s conversion value—calculated by multiplying the effective conversion ratio by the current stock price—and its bond value—the value assigned if there was no conversion feature. Sometimes, the conversion ratio may be a unit composed of two or more securities (in the case of a spin-off) or stock plus cash (in the case of a completed merger, where the convertible is left outstanding). On the other hand, an issue’s investment value (or bond value) is fairly easy to understand but more complicated to accurately derive. Thus, the conversion value and the investment value represent theoretical floors, below which the issue should not trade.

Once an issue’s conversion value is determined, and its investment value is estimated, the premiums over both of these values become the two most important factors in determining to what degree the issue is bond- or equity-sensitive and in estimating whether the issue is over- or undervalued. The issue’s premium over conversion value is simply its current price divided by its conversion value, expressed as a percentage, and its premium over investment value is the same formula, substituting estimated investment value for conversion value. The magnitude of an issue’s premium over conversion or investment value will determine how much the issue is exposed to changes in the price of the underlying common, interest rates, or both. For example, if an issue has a low premium over conversion value but a high premium over investment value, the issue will be very equity sensitive and have a high correlation to movement in the underlying stock, but be relatively insensitive to changes in interest rates. On the other hand, if the issue has a low premium over investment value but a high premium over conversion value, the opposite will be true—high sensitivity to interest rates, low sensitivity to changes in the underlying common’s price. If both premiums are modest or moderate, it will have moderate exposure to changes in both the price of the underlying stock and to interest rates. The combination of these premiums also helps to determine an issue’s upside potential versus downside risk (leverage projections). Furthermore, the magnitude of the premiums versus the convertible’s reward/risk ratio aids in evaluating whether or not an issue is over- or undervalued.

The last two features investors should be familiar with before purchasing convertibles are the call/put terms (if any) of the individual issues. Call provisions are the terms under which the issuing company can redeem (buy back) the convertible from the holder. In general, the warrant value (or conversion premium) of a convertible increases in value as the duration of its call protection increases. Callable issues, however, will trade at little or no premium if a call appears likely. A put feature is the ability to sell the convertible back to the issuing company, on a certain date, for either cash, stock, notes, or a combination of both. If a convertible is putable, it adds downside protection (another floor), providing the market believes the company can honor the put. “Hard” puts for cash are the most valuable.

Convertibles’ Flexibility

As most convertible investors know, investing in convertibles is a trade-off. As opposed to buying the stock outright, full participation in a stock’s upside potential is often traded for the downside protection a convertible’s yield advantage provides. Convertible investors will usually accept a lower yield than a straight (non-convertible) bond or preferred would offer because of the equity play holders have if the underlying common rises. Over time, some issues will become equity surrogates, some toward fixed-instrument vehicles, and others will hold the characteristics of a typical convertible. This creates a uniquely attractive feature of convertibles in that portfolios can be tailored to different market conditions, strategies and investors’ goals, yet still participate and be profitable if the market moves in an opposing direction. No matter which side of the market an investor wants to be in, chances are investors can utilize convertibles in hedge strategies to suit their purposes. Here are some of the choices investors have in designing a convertible portfolio:

Equity sensitivity, bond sensitivity or a combination of both. As mentioned, an issue’s premium over conversion value and premium over investment value determines how sensitive an issue is to movements in either the underlying stock or interest rates. Investors looking for equity plays should focus on convertibles with low premium over conversion value. Investors seeking yield plays should look for issues with low premium over investment value. In addition, investors seeking moderate exposure to both markets should look for issues with modest premiums over both, or the portfolio could be diversified to have some sensitivity to each market by having a mix of equity-sensitive and yield-sensitive convertibles.

Industry diversification or target market sectors. As a general rule, investors should diversify their convertible holdings, if possible, across 10 different issues in at least 10 different industries. This decreases their exposure to market risk and industryspecific risk. Still, for investors looking to bet on a rebound in a specific industry (e.g., financial services, high-technology, drug, etc.), convertibles offering favorable leverage (due to their higher yield, and thus greater downside protection versus the common), can be found in virtually all industry segments.

Focus on convertibles that are investment quality or “junk” grade and/or play the yield curve. Again, investors who buy convertibles accept a tradeoff. At issuance, buyers accept a lower yield (usually 1%- 2% below that of a “straight” bond of equivalent terms and quality) in return for the warrant component of the convertible (which provides participation in the underlying stock). Most convertibles offer higher yields than their underlying stocks and have more secure payouts than common dividends. Indeed, most convertible preferreds accrue missed payments and, in the case of convertible bonds, the company will usually lose some degree of control if it defaults. Also, convertibles have a higher claim on assets if the company goes into bankruptcy. As a result, the debt component of most convertibles offers holders downside protection. But the ability of the company to honor its payments now or in the future will depend heavily on this downside protection. Bond rating agencies have a range of investment grades, which represent a company’s risk of default on a specific issue. In our service, investment grades range from A (Highest) to L (Lowest and in bankruptcy). Our investment range of D (equivalent to an S&P rating of BBB) or higher, corresponds to issues considered of investment quality (low risk of default). Below-investment-grade quality issues (E or less in our service) are technically termed “junk” bonds. As the investment grade declines, the risk of default increases. Still, companies with investment grades of E, F and G are considered viable and should not be overlooked. The vast majority of convertibles outstanding are issued by small- to mid-sized capitalization companies and the investment grades of convertibles issued by these companies often fall within this range. Grades of H and I, however, should be viewed carefully.

The investment grade should establish a cutoff point for purchasing candidates. While investment-quality issues offer greater certainty that payments will be honored, yield rises as investment grades slide. Moreover, opportunities come around in which a financially secure convertible trades on its investment value, giving investor the warrant portion virtually free of cost. However, we caution that there are situations where a convertible that appears to be trading at or below its investment value may reflect market anticipation of a reduction in its investment grade—and the market is often right.

Playing the yield curve is another way to capitalize on investment grades and values. In this case, investors would focus on issues with a very high premium over conversion value that trade below their estimated investment value. Investors seek to capitalize on the issue’s price rising to its investment value. Such “busted” issues are often undervalued. This is because they are out of favor in the convertibles market and are unappreciated in the bond market, particularly in the case of junk convertibles. Another slant on this strategy is to shift investments to shorter maturities if interest rates begin to rise and then move back to longer maturities when rates appear to peak. One of the drawbacks of this particular strategy, however, is that the yield curve flattens rather than moves up across all maturities. This puts more downward pressure on the price of short-term issues than on long-term issues.

The ability to hedge convertibles. Although rising interest rates and falling equity prices are usually viewed as a convertible holder’s worst nightmare, there are various ways to hedge convertibles that will keep losses at a minimum and potentially produce gains, even in adverse market conditions. These strategies include selling stock short against convertibles, a strategy which offers the strongest downside protection to declines in the underlying common. Another common hedge strategy is writing call options against convertibles which can be tailored to provide varying degrees of downside protection as well as increase income. While there is no hedge strategy to protect convertibles against a rise in interest rates, a falling bond market is usually accompanied by a declining equity market. As a result, hedging the equity side of the convertible will often cushion the decline in its investment value.

Recap

Generally speaking, there are always plays to be made in the convertible market. For investors with a long-term view, a buy and hold strategy (riding out the short-term ups and downs) is a solid investment strategy. Still, for convertible investors who feel they can “time” market shifts and who want to hedge their positions, convertibles offer a wide variety of possibilities. In addition, for investors looking to make new investments, convertibles offer numerous possibilities for tailoring a portfolio’s sensitivity to either the equity market, the bond market, or both.