Published: May 29, 2009
The
correct answer is
(A.) Convertible bonds
Convertible bonds issued within the
last six months are up a remarkable
+46% for the year through mid-April.
They've handily trounced stocks in
the S&P 500, logging total returns
of +2.8% versus -11% for the first
quarter of the year. And further out
on the risk spectrum, more
speculative-grade convertibles
enjoyed returns of nearly +12%.
But the best news is convertibles
are still dirt cheap, despite the
strong showing. Convertibles, or
converts, are bonds or preferred
stock that convert into shares of
the underlying stock plus pay you
while you wait to convert. They come
in a variety of flavors, but most
offer a predictable income stream
and an equity kicker, which is like
a call option on the underlying
stock.
These bond/stock combos are perfect
fare for today's uncertain markets
-- the bond portion keeps the price
steady while the equity kicker lets
you play the coming stock market
rebound. Best of all, you don't have
to exercise your conversion
privilege to enjoy their benefits.
Studies by Merrill Lynch, Calamos,
Bank of America, and others have
found that converts tend to enjoy
more than half the gains when the
company's common shares rise but
fall less than half as much on the
way down.
Converts also allow you to hedge
your bets with a strategy of
convertible arbitrage. Since
converts typically move in the
direction of the underlying stock,
you can hedge your position by
holding the convert long and selling
short the underlying stock. That
way, if the stock price falls, the
loss on the convert should be offset
by the gain on the short stock
position. Or, if the stock price
rises, the corresponding uptick in
the convert should offset the loss
on the short stock position. Still,
for the arbitrage to work, the
convert and the underlying stock
must move in the same direction at
the same rate, and that doesn't
always happen. For example, if the
stock rallies sharply and the
convert doesn't, profits on the
convert may not offset losses on the
short stock position.
Convertibles trade as bonds or
preferred stock. Bonds are higher up
on the food chain, so their payments
are more secure, but preferred stock
trades on a major stock exchange so
can be easily bought and sold.
There are two primary types of
convertibles. Non-mandatory
(sometimes called vanilla)
convertibles give you the option but
not the obligation to convert into a
fixed amount of common shares at any
time. In contrast, if you hold
mandatory convertibles you can
convert any time but you can't sit
on your hands forever. But there are
lots of other bells and whistles and
no shortage of investment choices.
You can buy individual convertible
bonds or preferred stock, cover the
entire market in one fell swoop with
an ETF, or capture double-digit
yields from some dozen closed-end
funds that generally use leverage to
juice returns.
So how do you know what to do?
Simple. Check out StreetAuthority
editor Carla Pasternak's newsletter,
High-Yield Investing, to
learn more about converts that
appeal to investors at each end of
the risk spectrum. In the latest
issue, Carla takes an in-depth look
at the convertible bond market and
profiles two issues that offer hefty
yields (around 8%!) and steady share
price performance. To learn the
names of these bonds, and to learn
more about High-Yield Investing,
please visit this link.
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