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Portfolio > Mutual Funds > Bond Funds

Top 10 Questions & Answers About Convertible Bonds

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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.

In other words: premium and price go in opposite directions.

5. How and when do you convert the bonds?

One of the biggest misconceptions about convertible bonds is that investors should convert the bonds as soon as the underlying stock exceeds the conversion price.

Actually, you only should convert when forced to—typically because the bond is maturing or being called, with the stock above the conversion price. In other words, conversion only takes place at the end of the bond’s life.

Otherwise, if you want to take advantage of the stock’s rise, you do something easier than converting. You sell.

6. Aren’t convertibles only for hedge funds?

While it’s true that hedge funds are important participants in the convertible market, they are by no means the most natural buyers of convertibles. In fact, most convertibles are better suited to investors with far longer time horizons than hedge funds.

7. Why should I use a manager instead of buying convertibles directly?

In many ways, convertibles are the ideal asset for the individual. They provide the three characteristics most investors want: return of capital, current income and upside potential

Why, then, should investors use a manager instead of simply buying their own convertibles?

For the minority of investors — those with the time, resources and patience to choose and manage their own convertibles — this may be a solution. However, there is still a major difficulty. Retail investors generally are penalized when they trade individual bonds, including convertibles, with steep transaction costs. In addition, institutional investors are better positioned to evaluate special offers sometimes available to convertible holders — such as puts, one-time reductions in conversion price and inducements to extend maturities. 8. What are the biggest risks in convertible bonds?

For long-term investors, the largest risk in convertibles is issuer bankruptcy. The beauty of convertibles is that your investment can perform respectably even if the underlying stock does poorly. But it’s still important to avoid catastrophes.  If you stick with profitable companies, and focus on convertibles whose issuers have plenty of wherewithal to repay, you can generally avoid catastrophes without too much difficulty. Selling just because the price is lower is not necessary: selling when the fundamentals have changed significantly sometimes is.

9. How did convertible bonds perform in the financial crisis of 2008 and 2009?

Convertibles, particularly those issued by more speculative companies, experienced severe short-term losses during the financial crisis. This was primarily because many hedge funds, which had depended on Wall Street firms to lend them money for leverage, found their loans being recalled. The only course of action was to sell, regardless of price.

This forced selling by hedge funds created opportunities the likes of which few long-term convertible professionals had ever seen. Creditworthy issuers saw their paper trading with double-digit yields and very modest conversion premiums. It was, in short, the opportunity of a lifetime.

As markets stabilized in 2009, convertibles rallied back strongly to outperform stocks. The biggest lesson from the financial crisis is that while forced selling can take convertibles to remarkably cheap valuations in the short term, the essential value of the asset class will reward those who can stay the course.

10. What are the prospects for convertible bonds?

The zero-rate policy of the Federal Reserve, while enhancing the value of many existing convertible bonds, has created a new set of challenges. The new-issue market, a necessary source of convertibles, has been very slow in the low-rate environment. Many companies that traditionally would have raised money via the convertible market have been able to satisfy their requirements with non-convertible debt. Having said that, many convertibles continue to offer the blend of current income, capital preservation and upside potential that makes them unique, especially in volatile markets.  

Check out Abandon Bonds? Not So Fast on ThinkAdvisor.


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