Convertibles are made up of two parts: a fixed-income portion (which is bond-like) and a warrant (a call option on the underlying common stock). Thus, the value of a convertible depends on the sum of both parts. The bond value is the value of the convertible at maturity, without the warrant feature, discounted to the present value. This depends on many variables, such as the size of the coupon, the company’s investment quality and financial strength, and the amount of time to maturity. The warrant portion gets its value from the activities of the underlying common stock; the more the stock advances, the higher the value of the warrant, and vice versa.

Common stocks ranked 1 or 2 by our sister publications, The Value Line Investment Survey and The Value Line Investment Survey Small and MidCap Edition, are deemed to have the potential to outperform the market averages in the upcoming six to 12 months. Convertibles are assigned ranks based on the attractiveness of their total return potential. The rank of the underlying common stock contributes significantly to the ranking of the convertible, as it pertains to the warrant portion of the security. So, if the underlying stock is ranked for above-average performance, the convertible’s potential total return is likely to be above average. That said, because convertibles are a hybrid instrument between a bond and a stock, they generally do not share fully in gains in the stock. On the other hand, convertibles generally offer income above that available from the common and often a relatively lower level of risk.

As the conversion value approaches the price of the convertible, the premium at which the convertible trades tends to gradually disappear. The lower the premium over conversion value, the greater is the convertible’s participation in the upside of the underlying stock. Convertibles trading above par generally tend to have the lowest premium over conversion value. And the smaller the premium, the more likely the convertible will mirror the activities of the underlying stock. Thus, convertibles with low premiums over conversion value enable portfolios to reap the returns of the underlying common stock, at much less risk, and in the process, gather income that is usually higher than that available from the stock.

We screened our database for favorably leveraged convertibles, trading at premiums over conversion value of 20%, or less, and whose underlying common stocks are ranked for above-average performance. These convertibles display greater sensitivity to their respective underlying common stocks, and have the potential to rise more than they would fall, if the stock rises or falls 25%. Such convertibles can allow investors to increase income and reduce risk, as compared to holding just the underlying stocks, while achieving performance that, at times, could be roughly similar to owning the underlying stock.

* Prices as of 5/31/2011

Highlighted Convertibles:

Alliance Data Systems (ADS), together with its subsidiaries, provides data-driven and transaction-based marketing and customer loyalty solutions. It offers marketing services, including coalition and stand-alone loyalty; and analytical, strategic consulting and creative, proprietary data, database marketing services, and interactive communications.

Alliance reported a $2.03-a-share profit for the first quarter, which was $0.65 (or 47%) higher than it earned for the same time a year earlier, thanks to growth in all three of its businesses, and expects more favorable quarterly comparisons for the rest of the year

The company is expanding into the Brazilian market. An agreement to roll out Dotz’ (33% owned by ADS) loyalty program across the country was signed with Banco de Brazil. A recent acquisition (Aspen Marketing) is expected to boost Alliance’s Epsilon division data, analytics, and distribution capacities, while providing exposure to customers in the automotive and telecom industries.

Alliance Data’s 1.75% convertible notes due 2013 represent an excellent alternative to the risky common stock. The notes are more stable in price, and they generate income in comparison to the common, which does not pay a dividend. In addition, for any upward move in the stock price, the convertible can potentially share in as much as 76% of that gain. 

Iconix Brand Group (ICON) changed its business model from manufacturing shoes to the licensing of various trademarks in 2003. In mid-2005, it changed its name from Candie’s, and licenses its brands to retailers and manufacturers worldwide. Iconix owns and manages a portfolio of consumer brands, including Candie's, Badgley Mischka, Joe Boxer, Danskin, Rampage, Ocean Pacific, Mossimo, London Fog, Rocawear, Bongo, Starter, Mudd, and others, and supports its brands through advertising and product development. The Value Line Investment Survey expects earnings to ramp up rapidly in the coming years, as the company expands into foreign markets.

The Iconix Brand 1.875% convertible notes mature in about a year. While the notes are slightly in the money, any increase in the common price should be reflected in the value of the convertible. Of note, the stock price is only $4.28 off the conversion price of $27.56 a share.

VeriFone Systems (PAY) engages in the design and marketing of system solutions for electronic payment transactions and value-added services. Its system solutions include point-of-sale electronic payment devices, security and encryption software, and certified payment software, as well as third party applications. In March, the company announced that it is on track to complete the acquisition of Hypercom Corporation by the second half of 2011. VeriFone and Hypercom also announced an agreement to sell the U.S. payment systems business of Hypercom to Ingenico S.A. The company earned $0.35 a share in the first quarter of 2011.

VeriFone’s 1.375% convertible notes due in 2012 trade deep in the money. With an 11% premium over conversion value, it is poised to share in as much as 70% of any increase in the common stock price. Then, as the premium decreases to zero, the convertible’s sensitivity heightens and could mirror the activities of the underlying common.

At the time of this article's writing, the author did not have positions in any of the companies mentioned.