Uncertainty about the direction of the equity markets and economic conditions has investors scurrying to find safe havens for their investment dollars. While bonds provide such safety, yields are currently very low and there is little potential for capital appreciation over the long term. And the low interest-rate environment makes the return on holding cash virtually non-existent. Convertible bonds, however, offer an interesting middle ground between the safety of bonds and the upside potential, and risk, of stocks.
Because of the high volatility being experienced in the equity markets, convertibles are trading with high premiums over conversion value as their underlying common stock prices decline. In fact, as of August 13, 2010, the average convertible traded with a 52% premium over conversion value and a 17% premium over investment value. Such conversion premiums limit the convertibles’ participation in the stock price movements. But, despite rather lackluster economic conditions, we can still find a few companies whose stocks are performing well and the convertibles issued by these companies are also doing well.
We screened our database for convertibles ranked 1 or 2, whose underlying common stocks were ranked 4 or 5 by Value Line, and found 42. The average current yield of the group is 6.1% compared to 0.9% from all the common stocks. Even if we measured only the common stocks paying dividends, the average convertible in this group would generate a yield of 6.1% versus 3.6% from the underlying stocks.
In the convertible security space, there are basically two types of products: Convertible bonds and convertible preferred stocks. In this screen, we reviewed our database for convertible preferred stocks with the widest yield spread between the convertible preferred and the underlying common stock. Many of these preferred stocks are trading below their liquidation value, which results in large yields relative to their underlying common stocks.
Convertibles are made up of two parts: a fixed-income portion (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. 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. Here, 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.
Real Estate Investment Trusts (or REITs) are companies engaged in the purchasing, development, management, and sales of real estate assets. In essence, they pool investors’ money and invest in real estate or real estate-related assets, such as shopping centers, office buildings, hotels, and mortgages secured by real estate.
Often times, the best investment in a Biotechnology or Drug company is to buy debt offered by it. In general, these companies seek financing for their development through the issuance of corporate bonds or preferred stocks. These debt instruments, and particularly convertible debt issues, provide income while exposing convertible investors to the movements of the underlying common stock should the company’s product become commercially successful.
The Value Line Investment Survey ranks industries based on the amount of top-ranked stocks within each industry. These industries, as well as the stocks listed therein, are expected to outperform market averages in the next six to 12 months. We believe the convertibles, whose underlying common stocks are listed in these top industries, represent a good starting point for investors seeking new convertible ideas.
The Performance Rank assigned to a convertible by our model indicates how that convertible is expected to react to market conditions in the upcoming six to 12 months. A convertible will not be ranked, however, if its underlying common stock is not ranked by either The Value Investment Survey or its sister publication, The Value Investment Survey Small and Mid-Cap Edition, or if a once-ranked common stock has had its rank suspended. Still, the absence of a rank is certainly not an indication that a convertible will not do well over the year ahead.
The conversion feature of a convertible security (the call option) hardly has any value if the common stock underlying that convertible trades below the effective conversion price. Convertibles in this situation are usually referred to as “busted” convertibles because they trade at high premiums over conversion value.
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High-Yielding Convertible Bonds - August 25, 2010
Uncertainty about the direction of the equity markets and economic conditions has investors scurrying to find safe havens for their investment dollars. While bonds provide such safety, yields are currently very low and there is little potential for capital appreciation over the long term. And the low interest-rate environment makes the return on holding cash virtually non-existent. Convertible bonds, however, offer an interesting middle ground between the safety of bonds and the upside potential, and risk, of stocks.
Surrogate Convertibles with a Current Yield Advantage over Underlying Common Stocks
Because of the high volatility being experienced in the equity markets, convertibles are trading with high premiums over conversion value as their underlying common stock prices decline. In fact, as of August 13, 2010, the average convertible traded with a 52% premium over conversion value and a 17% premium over investment value. Such conversion premiums limit the convertibles’ participation in the stock price movements. But, despite rather lackluster economic conditions, we can still find a few companies whose stocks are performing well and the convertibles issued by these companies are also doing well.
Convertibles Screen: Top Convertibles with Poorly Rated Underlying Common Stocks
We screened our database for convertibles ranked 1 or 2, whose underlying common stocks were ranked 4 or 5 by Value Line, and found 42. The average current yield of the group is 6.1% compared to 0.9% from all the common stocks. Even if we measured only the common stocks paying dividends, the average convertible in this group would generate a yield of 6.1% versus 3.6% from the underlying stocks.
Convertible Screen: Convertible Preferred Stocks with the Widest Yield Advantages over their Undelrying Common Stock
In the convertible security space, there are basically two types of products: Convertible bonds and convertible preferred stocks. In this screen, we reviewed our database for convertible preferred stocks with the widest yield spread between the convertible preferred and the underlying common stock. Many of these preferred stocks are trading below their liquidation value, which results in large yields relative to their underlying common stocks.
Convertibles Screen: Convertibles with Favorable Equity Participation in their Underlying Common Stocks
Convertibles are made up of two parts: a fixed-income portion (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. 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. Here, 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.
Convertibles Screen: Real Estate Investment Trusts (REITs)
Real Estate Investment Trusts (or REITs) are companies engaged in the purchasing, development, management, and sales of real estate assets. In essence, they pool investors’ money and invest in real estate or real estate-related assets, such as shopping centers, office buildings, hotels, and mortgages secured by real estate.
Convertibles Screen: Opportunities in the Biotechnology and Drug Industries
Often times, the best investment in a Biotechnology or Drug company is to buy debt offered by it. In general, these companies seek financing for their development through the issuance of corporate bonds or preferred stocks. These debt instruments, and particularly convertible debt issues, provide income while exposing convertible investors to the movements of the underlying common stock should the company’s product become commercially successful.
Convertibles Screen: Convertibles in Top Industries
The Value Line Investment Survey ranks industries based on the amount of top-ranked stocks within each industry. These industries, as well as the stocks listed therein, are expected to outperform market averages in the next six to 12 months. We believe the convertibles, whose underlying common stocks are listed in these top industries, represent a good starting point for investors seeking new convertible ideas.
Convertibles Screen: Unranked Convertibles
The Performance Rank assigned to a convertible by our model indicates how that convertible is expected to react to market conditions in the upcoming six to 12 months. A convertible will not be ranked, however, if its underlying common stock is not ranked by either The Value Investment Survey or its sister publication, The Value Investment Survey Small and Mid-Cap Edition, or if a once-ranked common stock has had its rank suspended. Still, the absence of a rank is certainly not an indication that a convertible will not do well over the year ahead.
Convertibles Screen: Busted Convertible Bonds
The conversion feature of a convertible security (the call option) hardly has any value if the common stock underlying that convertible trades below the effective conversion price. Convertibles in this situation are usually referred to as “busted” convertibles because they trade at high premiums over conversion value.