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Published: August 24, 2009
The Dow Jones Industrial Average has rallied
more than 2,500 points, climbing from a March low near 6,500 to
retake the 9,000 level. That's a +40% advance in less time than
it takes to grow a tomato.
So is the market set to roar past 10,000? Or is it about to roll
over and retreat?
Investors could jump back in now and watch their money disappear
in a violent reversal. Or stocks could break out to new highs
and leave investors behind. I don't find either option
appealing.
Fortunately, there's a middle ground, one that allows investors
to participate in a rising market without getting whipsawed if
the bottom drops out. Convertible bonds were made for this kind
of volatile environment. Regardless of which path the market
takes, these unique securities will put profits in investors
pockets.
Convertibles are hybrid securities that pair the reliable income
of a bond with the potential capital appreciation of a stock.
Convertible bonds work like traditional corporate bonds. They
offer fixed, semi-annual interest payments. The difference is
these securities come with the opportunity to convert into a
pre-determined number of regular common shares at some point in
the future.
That's a nice bonus.
A new bond with a $1,000 par value, for example, might be
convertible into common shares at a price of $40. In that case,
each convertible would represent 25 common shares ($1,000/$40).
Should the common shares rise above the conversion price, let's
say to $50, then investors can opt to forgo any future interest
payments and exchange the convertible for 25 common shares for a
profit.
Generally speaking, stocks must rise about +25-30% before the
conversion feature kicks in.
That's exactly what happened with Alcoa (NYSE: AA). The aluminum
producer issued new convertibles on March 19. During the next
month, the common shares increased from $6.40 to more than
$9.00. That increased the conversion value of the convertible
bonds, and they spiked about +60% in response.
But here's the beauty: You don't have to convert if the common
stock fails to budge or even loses ground. Just sit on the bond
until maturity and your principal will be repaid in full while
you collect regular interest checks along the way.
This versatility is what makes
convertibles the perfect all-weather
asset class. These securities
typically capture two-thirds of the
market's upside potential, with only
one-third of its downside exposure
according to convertible bond
experts.
As you might expect, the equity
conversion feature isn't a freebie.
Owners usually accept lower interest
rates than they could get with
similar corporate bonds -- three to
four percentage points. Many
investors are more than happy to
make that tradeoff.
Companies find convertibles to be a
creative way to raise cash in a
rough market. Not surprisingly, the
convertible bond market has tripled
in size from $65 billion in 1990 to
$180 billion today.
If the market tumbles, and
convertibles appear unlikely to be
exchanged, they will lose their
equity characteristics and trade on
their fixed income value. That's
what happened last year when forced
selling by hedge funds decimated the
market. During the height of the
panic last fall, the pool of buyers
dried up and the market fell more
than -30% in a matter of months --
its worst setback on record.
Convertible bonds have recuperated
this year. More than 90 new issues
have come to market since January,
raising $33 billion. Convertibles
gained +21% through the first half
of the year -- trouncing the +11%
return of the S&P 500.
That's a risk to reward imbalance
that anyone can appreciate.
Here's an example of how convertible
bond funds have fared this year.
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The market is still sharply underpriced and dozens of issues
are "busted," meaning they trade as pure bonds with zero value
attached to their equity options.
It's easy to see why some are now referring to convertibles as
free lottery tickets -- if the underlying stocks rise in value,
investors can convert their hybrid security for a nice profit
without any additional costs than a typical bond.
Good Investing!
-- Nathan Slaughter
Editor
StreetAuthority Market Advisor |
