Risk typically increases with potential return. In other words, to achieve higher returns, one normally needs to take on greater risk. There are, however, some investments that historically have provided larger-than-expected returns in proportion to the risk of the securities involved. Convertibles fall into this category.
There are several reasons for this. First, convertibles are higher in the capital structure than stocks, so if a company were to go bankrupt, bond and preferred holders would get compensated before common stock owners.
Second, because of the covenants included in debt-oriented instruments, companies tend to discontinue bond interest or preferred dividends only as a last resort. This is because such a move would likely put the company in default of the debt covenants and the bond and preferred holders could take control of the company or, at the very least, get more say in the company’s governance. Some convertible securities provide flexibility on this for the company, but the end result is eventually the same. So, if a company’s earnings decline, it might skip common stock dividends but would likely only discontinue paying on the convertibles as a last resort.
Third, convertible securities almost always offer a higher yield than the common stocks of the issuing company. So, even if the price of the common stock falls, the higher yield provides an additional level of support for the convertibles. Moreover, the higher distribution provides a return even during times when a shareholder would have experienced a loss, even if it only on a “paper” basis.
What all this means is that fairly priced convertibles are almost always “favorably leveraged.” In this case, we are using the term leverage to describe the price movement of one issue relative to another. An issue is described as “favorably leveraged” if it will rise more on an increase in the underlying stock than it will fall on a decline in the stock. The average convertible is leveraged since it is free to participate in a rise in the stock price, but its higher yield generally limits the extent of any drop.
The following illustration will help to explain this point:
The graph below depicts a typical convertible. It has a “conversion value” that rises as the stock rises, and an “investment value” that remains reasonably constant. Because the issue converts into a fixed number of shares, its conversion value rises in line with the rise in the underlying stock. Its investment value, meanwhile, is the price it would sell at if it was not convertible, that is, if it were a “straight” bond or a preferred stock of equal quality, paying equal interest or dividends.
The investment and conversion values are “floors” that support the price of the convertible. If the convertible’s price dipped below conversion value, arbitrageurs would snap it up, convert it and sell the common shares to make an instant profit. Similarly, if its price dipped below the investment value, income-oriented investors would snap it up to get the conversion privilege for free. Assuming the company is healthy and there is no change in interest rates, the investment value is a relatively constant value.
The dotted line traces the price path along which the convertible trades. Notice that it usually trades at a premium over both its conversion and its investment value. This is so because investors are willing to pay more than conversion value to capture the income from the security, since it is usually higher than that available from the common stock. Moreover, investors pay more than investment value because there is the chance that, if the stock rises, the convertible’s price will rise, too.
Examine the price path of the convertible. You can see that at any point, the convertible will rise faster than it will fall. Thus, the average convertible is favorably leveraged, allowing it to share in a greater proportion of any rise in the stock than in any decline. Over time, this has historically allowed this security type to provide better returns and less risk.