Investing 101: Why Buy Convertible Bonds?

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Why Buy Convertible Bonds? by David Merkel, CFA of Aleph Blog

I sometimes answer questions for those at Klout.com that ask basic investing questions.  Usually I point to old articles of mine, but this time someone asked a question that I have not answered before, and here it is:

What’s a convertible note? I’ve Googled for the answer but can’t find a simple answer. Why would one take a note when investing rather than equity?

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Some people want the best of both worlds.  I want upside potential, but I want a guaranteed downside where I still make money.  That’s a convertible bond (or note, same thing).  The convertible bond promises to pay you income though interest payments, but allows for the possibility that you will want to exchange the bond for a fixed number of shares in the company.  When would you want to do such an exchange?  You would exchange when the stock price rises to the point where the bond is worth more converted into stock.

Investing 101: Why Buy Convertible Bonds?

Let’s look at this question from the other side for a moment.  Why would a company issue a convertible bond?  There are several reasons:

  • Typically, companies that issue convertible bonds have credit ratings that are junk or low investment grade.  They want a low interest payment for a company of their credit quality, and so they trade potential issuance of more stock at a time where it would hurt, for lower current interest payments.
  • Often, the companies that offer convertible bonds are growth companies that need capital, but they might have a hard time doing an ordinary junk bond.  Convertible bonds have a ready buyer base.
  • Convertible bonds can be the “financing of last resort” for companies that are in financial trouble.  (Article one, article two)

Now, many convertible bonds are issued by companies that subsequently don’t do well, and the bonds get bought by junk bond managers who buy them as junk bonds — they are called “busted converts.”  They trade as if there is no conversion option, and some clever junk bond managers buy them, knowing that if a few of them have stocks that rally significantly, they will make enough extra money to aid their performance.

For what it is worth, the same ideas apply to convertible preferred stock, except that is bought primarily by individuals, while the bonds are bought by institutional investors.  Also note that preferred stock has weaker credit quality than bonds.  In liquidation, bonds get paid before preferred stock.

Final Notes

Convertible bonds changed when hedge funds emerged to invest in cheap convertible bonds, because the conversion option was frequently undervalued.  As they became a larger force in the market convertible bonds rose in value, until they were largely not attractively priced.

Prior to that era convertible bond funds regularly outpaced other bond funds.  They behaved kind of like a funny type of balanced fund.

As an investment grade corporate bond manager, I bought a convertible bond once, where it was “busted,” and was attractive just for the income alone.  As it was, after I left the firm, the stock rallied to the point where converting to stock made sense.

This is tough: convertible bonds make sense for those that want the possibility of extra income if the stock price rises, but are willing to take a lower income on the convertible bond versus straight debt.

Oh, one more thing, again, generally only lower rated companies issue convertible debt, so you have to live with a higher level of default risk.  Yes, convertible bonds offer the best of both worlds… so long as the issuer doesn’t default.

 

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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