Know any clients that might be looking for a viable fixed income strategy?
Convertible bonds might be the answer, and for that reason are receiving more attention at the moment — mainly because it’s a fixed income product that increases as interest rates rise, says Greg Miller.
Miller, CEO and co-CIO of Wellesley Investment Advisors, specializes in convertible strategies. Although you might think advisors know the basics of the asset class, you’d be wrong, he argues, and has made it his mission to raise advisors’ awareness and expertise.
A simple primer is the best way to get started, and he helpfully answers the pressing questions below.
1. What are convertible bonds?
Convertible bonds, most importantly, are bonds. They carry all the same promises of repayment of principal and interest of all corporate bonds.
Unlike other bonds, though, convertible bonds give holders the ability to participate in the upside of the issuing company’s shares. Investors in convertibles have the right — but not the obligation — to convert their bonds in order to receive greater value than the promised principal repayment.
They have several defining features, including: coupon (the promised annual interest rate), maturity, calls and puts and conversion ratio.
Convertible bond coupons are typically lower than coupons of otherwise similar nonconvertible bonds. Some convertibles are simply issued with relatively short-term maturities, such as five years. The conversion ratio, specified in a convertible’s initial documentation, also defines a bond’s conversion price. Most convertible bonds are issued in units of $1,000. A conversion ratio of 25 thus implies a conversion price of $40 (1000/25).
2. Why should advisors (and clients) be interested?
In a time of unprecedented low interest rates and high volatility, investors must reconcile their need for income and growth with their understandable desire to protect capital. Convertible bonds can be the solution.
A well-chosen convertible bond, bought at the right price, promises no worse than the full return of the original investment, plus the opportunity for significant upside as long as the issuer remains solvent. The rule of thumb is that convertibles typically offer, in the medium term, two-thirds of the upside of stocks with one-third of the downside. But in the longer term, convertibles do even better. Studies have shown that convertibles actually outperform stocks over extended periods, when you take both capital appreciation and coupon income into account.
3. If I think a stock is going up, shouldn’t I just buy the stock?
It’s true that on the upside, convertibles tend to underperform their underlying stocks. This is because when you buy convertibles, you effectively pay a premium to the market price of the stock. Think of it as buying insurance along with your stock. The insurance premium lets you sleep better, knowing that in almost all cases you’ll do no worse than recoup par value for your bonds. If you are disciplined about the prices you pay for convertibles, this essentially means you’ll get your money back, even if the stock goes down significantly.
How much does the premium cut into your upside? A good rule of thumb is to subtract the conversion premium from 100%. If you buy a convertible whose price reflects a 30% premium to the stock price, and hold the convertible for an extended period, it’s reasonable to estimate that you’ll participate in about 70% of the stock’s upside.
So, you may ask, why give up so much upside?
The answer is simple: while you may think the stock will go up, you don’t know that it will. Some of your expectations may not pan out. Even if they do, the market may decide not to agree with you.
4. Can you explain the basic math of convertibles?
To understand convertibles, you just need to get comfortable with a few calculations. One is premium. This is the amount by which a convertible’s price exceeds the value of the shares it converts into. Bonds with low premiums offer almost as much upside as their underlying shares. However, they are also subject to greater losses, because low-premium convertibles usually trade well above the par value you receive at maturity.
Bonds with low premiums trade at higher prices — usually well above 100. Higher-premium bonds, meanwhile, are associated with lower prices.