No Good or Bad Bonds, Just Good or Bad Prices…

It’s important to be careful here. Convertible bonds are not necessarily superior investments. As with anything else, if you pay too much you’ll end up with a poor risk/reward tradeoff.

Let’s say that while you didn’t buy the XYZ convertible when it was issued at $100, a lot of other people did. That would push the price all the way from $100 to $125 even as XYZ stock remained at $80. This is rather unrealistic, but it will illustrate an important point.

Now that our starting point is $125, not $100, let’s look at our original example where the stock doubled from $80 to $160. You can take $100 from the company or convert into stock worth $160. The right choice, as before, is to convert. You will still make money from your investment at $125. But your return -- getting back $160 after putting in $125 -- is only 28% before counting the interest income you collected. Even after factoring in the 20 points of interest you got over the 5 years, your return is only 44% on a stock that doubled. It’s hard to argue that you participated sufficiently in the stock’s upside.

So, if you overpay for a convertible, you damage your performance. You can even damage it to the point where you’re defeating the whole purpose - protecting your downside while allowing for significant upside. It’s absolutely not the case that you should always buy convertibles instead of stocks.

These Days, The Prices Are Good (for Buyers) - A Brief History Lesson

In the first years of this decade, when stocks fell sharply in the bust phase of the dot-com boom, convertible bonds maintained their values quite well. As a result, so-called convertible-arbitrage hedge funds, which buy convertible bonds and sell short the stocks into which the bonds can be converted, provided strong positive returns amidst a falling stock market. This led to massive flows of money into these hedge funds.

In previous markets, most convertible bonds were owned by more traditional unhedged investors, such as mutual funds and insurance companies. They used converts to make longer-term equity investments. But hedge funds, after generating strong returns in a weak equity market, became the dominant investors in convertibles.

Subsequently, the convertible-arbitrage funds, forced to deploy large new sums of money into a relatively fixed pool of securities, drove prices to the point where returns almost had to suffer. And suffer they did. Convertible-arbitrage returns, well into double digits in 2000-2002, were lower in 2003, flat in 2004 and sharply negative in 2005 as the fast money went in the other direction. Some long-term convert-market professionals said that in 2005 they hadn’t seen such cheap valuations for decades.

Indeed, 2006 provided great relief for converts as the forced selling of 2005 came to an end and the bonds once again approached their theoretical values. Many hedge funds that had survived 2005’s storm returned upwards of 20%. 2007 began well for convertible funds, but the market suffered amidst a summer financial crisis. Convertibles rallied in the fall and actually began 2008 with a strong January.