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Convertible Bonds: An Investor's Best Friend, Part 3


All the upside, but better downside protection.


Editor's Note: Bill Feingold has been a convertible portfolio manager, trader and analyst for 15 years and has taught and written about convertibles and options. He is a summa cum laude economics graduate of Yale and received an MBA with distinction in finance from Wharton.This is part 3 of a 3-part series. Part 1 can be found here; Part 2 can be found here.

Previously, I discussed the basics of how convertible bonds work and the events that have created this historic buying opportunity, both in an absolute sense and relative to stocks.

But a major question remains: How do you do it?

First, the bad news: Buying corporate bonds has long been a complex and opaque process for individual investors. This has pushed retail fixed-income buyers toward mutual funds. There's nothing necessarily wrong with this, although part of the beauty of owning bonds is the essential knowledge that, short of bankruptcy, you know what you will receive and when you will receive it.

But when you buy a mutual fund you put yourself at the discretion of the fund manager. While you get the benefits of professional management and wholesale pricing, you are subject to the risk that the manager may make forced or semi-forced sales at inopportune times.

Trying to get identifying information for bonds, beginning with knowing which companies even have convertible bonds outstanding, is time-consuming for the individual. The biggest challenge is finding a broker who can get you both a reasonable price and actually find bonds.

That's the bad news.

The good news is that I'm hopeful that the absolute destruction we've seen will enable discussions and endeavors that would have been laughed at a year ago. The technology is certainly there to make generic bonds and convertible bonds particularly accessible to smaller investors.

But with the collapse of so many hedge funds, I'm optimistic that the corporate-bond market will make itself more available to new investors, such as institutions previously focused on equities and individuals

The Critical Information

I suggest you start with stocks you already own. Convertibles are well-represented in most important sectors, particularly technology, health care, energy and, of course, financial services. A word of caution on financials: Their convertibles are often preferred shares, not bonds, and as such do not offer the same assurance of principal repayment.

There are many ways you can find out if a company you already own has a convertible. One quick way is to do an Internet search using the name of the company (not the ticker) and the word "convertible." In all likelihood if the company has issued convertibles you'll see relevant information among the first listings.

You need to learn the following basic information about a convertible:

  • Coupon
  • Conversion ratio/conversion price
  • Maturity, calls and puts

The coupon, as you probably know, simply means the annual interest rate. Most bonds are denominated in units of $1,000. A 3% coupon means you receive $30 interest annually per $1,000 face amount.

The conversion ratio is the number of shares into which you have the right to convert, generally per $1,000 face amount. A conversion ratio of 40 would mean you have the right to exchange each $1,000 face amount for 40 shares of stock. By dividing the conversion ratio into the face amount you arrive at the conversion price, which in this example would be $25 per share.

Every bond has a maturity - the date at which the company must repay the principal. However, companies frequently issue bonds with one or more puts, or specific dates before the maturity at which the holder has the right to force the company to repay the principal. You should focus on the put date closest to today when thinking about the minimum (excluding bankruptcy) return of your investment.

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No positions in stocks mentioned.

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