Convertible Bonds Raise Ceiling of Opportunity

What do you do when you can’t decide whether stocks or bonds are the better buy? You might consider a hybrid combination of both called convertible bonds.

Convertible bonds are corporate debt that can be converted into company stock at a specific price and time in the future.

These bonds can be attractive because they have some of the positive characteristics of both stock and bond investments. They pay a set rate of interest just like a bond. But, because they can be turned into shares of a company’s stock, they also can appreciate when the price of company shares rises.

In normal times, convertible bond prices are a bit less volatile than either stocks or bonds because the interest coupon puts a “floor” under the price when the company’s stock price falls, experts say. And the ability to convert the investment into stock puts a “floor” under the price when interest rates rise.

The disadvantages of convertible bonds? When times get really tough, these “floors” can collapse and investors may fall farther and faster than they would if they had simply stuck to either investing in stocks or bonds.

When the stock market crashed in 1987, for example, the convertible bond market actually did worse, according to one recent study. And that’s not surprising, said Edward Jamieson, vice president and senior portfolio manager at Franklin Advisers in San Mateo.

When interest rates are rising and the stock market is falling, convertible bonds are bound to get crushed. That’s because their selling price is based both on their yield and on expectations for the company’s stock.

All bonds suffer when interest rates rise because newly issued, higher-rate bonds and certificates of deposit begin to look comparatively more attractive. As a result, old, lower-rate bonds will sell at a “discount.”

When the stock market is falling at the same time, convertible bonds are hit hardest because they generally have farther to fall. Normally convertibles sell for a bit more than comparable non-convertible bonds (a “premium”) because the market takes into account the potentially valuable right to convert this bond into stock in the future. When that right becomes worthless, the premium evaporates.

Another disadvantage of convertibles is that they are harder to evaluate than either straight stocks or straight bonds.

To determine whether a bond is a good deal, for example, investors normally must look at its yield and whether the borrower is credit worthy. They also have to examine “call dates,” which are points in time when the bond issuer can pay off all holders early. (Early calls reduce the value of the bond.) And they must consider interest rate expectations, since their bond will decline in value if interest rates rise.

If you want to know whether a stock investment is wise, you must consider a variety of other factors, including dividend yield, market price compared to earnings and the company’s prospects. It also makes sense to evaluate prospects for the entire industry, since Wall Street tends to boost and bash whole industry groups often without regard to specific company attributes.

To determine whether a convertible bond is a good buy, you’ve got to evaluate all those factors at the same time. And that isn’t easy, even for the pros.

For this reason, most experts suggest that individual investors get help when trying to enter the convertible bond market. They can do that either by investing through a mutual fund or by using professional research reports as part of their own analysis of particular bonds.

Clearly, the mutual fund route is easiest. All you have to do is collect and read through prospectuses from a variety of convertible bond funds. You then match the fund’s investment strategy to your own--conservative, aggressive, etc. And compare the funds based on historic returns and fees. Those that tend to hold investments for long periods should be particularly cognizant of annual marketing fees that are normally charged in lieu of an up-front sales charge, or “load.” High annual marketing fees can cost investors more than a load in the long run.

If you decide to evaluate bonds on your own, you might want to ask your broker for research reports on the companies you are considering. Aside from research reports put out by full-service brokerage firms, there are a number of private outfits that do nothing but research. One such service is Value Line, which publishes its own convertible securities “recommended list.” These reports are not a substitute for your own evaluation--they’re simply a good supplement.