Convertibles: Safer Than Stocks, Yet More Profitable!
Risk typically increases with potential return. To achieve higher returns, one normally needs to take on greater risk. There are, however, certain investments that historically have thrown off larger returns in proportion to risk than would be expected. Convertibles fall into that category.
It is easy to understand why convertibles are lower in risk than common stocks. First, they are of higher quality. If a company's earnings decline, it might skip its common dividend but would discontinue paying bond interest or preferred dividends only as a last resort, for if it did, bond and preferred holders could take control of the company. Further, if a company did fail, bond and preferred holders would get paid off before common stock holders. In addition, convertibles almost always offer a higher yield than stocks. So, if the price of the common falls, the higher yield helps support the bonds and preferreds.
What this means is that fairly priced convertibles are always "favorably leveraged." Leverage describes the price movement of one issue relative to another. A warrant is highly leveraged; it will rise or fall faster than its underlying stock. A convertible almost always moves more slowly than its underlying stock. An issue is described as "favorably leveraged" if it will rise more on a rise in the underlying stock than it will fall on a decline in the stock. Convertibles are favorably leveraged since they are free to participate in a rise in the stock, but their higher yields limit the extent of any drop.
Here's how this works: A typical convertible has a "conversion value" that rises as the underlying stock rises, and an "investment value" that remains reasonably constant. Because the issue converts into a fixed number of shares, its conversion value rises in line with the underlying stock. And its investment value is the price it would sell at if it weren't convertible, that is, if it were a "straight" bond or preferred stock of equal quality paying equal interest or dividends.
The investment and conversion values are "floors" that support the price of the convertible. If the convertible's price dipped below conversion value, arbitrageurs would snap it up, or convert it and sell the common to make an instant profit. Similarly, if the price dipped below investment value, income-oriented investors would snap it up to get the conversion privilege for free.
How a convertible trades: It usually trades at a premium over both its conversion and its investment value. Investors may pay more than conversion value because the convertible pays higher income than the corresponding common stock. And investors may pay more than investment value because there is a chance that if the stock rises, the convertible's price will rise, too.
If you examine the price path of a convertible, you can see that at any point, the convertible will rise faster than it will fall. This, then, is favorable leverage; it follows that the convertible must have a better risk/reward ratio than the stock, for it will share in a greater proportion of any rise than in a decline.
Studies show that convertibles consistently outperform common stocks, over periods of five years or more. Why this should be so is best explained if we look at what happens in various phases of the market. When the market falls, it's easy to see that convertibles will do better. Not only do they fall less, but they also provide greater income. In a flat market, their greater income is the deciding factor. In a rising market, convertibles do not normally appreciate in price as fast as the common, but if the market rise is slow, the greater income from convertibles causes the total return from convertibles to equal or exceed the total return from common stocks. Only in a rapidly rising market, then, do convertibles fall behind. That convertibles have historically outperformed common stocks suggests what we already know, that stocks don't spurt upwards most of the time.
And finally: One of the most attractive features of convertibles, a feature pointed out by consultants to pension funds, is that a convertible portfolio will typically be less volatile than a portfolio of common stocks... which means that convertibles offer investors a more favorable risk/reward ratio than common stocks.
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It is easy to understand why convertibles are lower in risk than common stocks. First, they are of higher quality. If a company's earnings decline, it might skip its common dividend but would discontinue paying bond interest or preferred dividends only as a last resort, for if it did, bond and preferred holders could take control of the company. Further, if a company did fail, bond and preferred holders would get paid off before common stock holders. In addition, convertibles almost always offer a higher yield than stocks. So, if the price of the common falls, the higher yield helps support the bonds and preferreds.
What this means is that fairly priced convertibles are always "favorably leveraged." Leverage describes the price movement of one issue relative to another. A warrant is highly leveraged; it will rise or fall faster than its underlying stock. A convertible almost always moves more slowly than its underlying stock. An issue is described as "favorably leveraged" if it will rise more on a rise in the underlying stock than it will fall on a decline in the stock. Convertibles are favorably leveraged since they are free to participate in a rise in the stock, but their higher yields limit the extent of any drop.
Here's how this works: A typical convertible has a "conversion value" that rises as the underlying stock rises, and an "investment value" that remains reasonably constant. Because the issue converts into a fixed number of shares, its conversion value rises in line with the underlying stock. And its investment value is the price it would sell at if it weren't convertible, that is, if it were a "straight" bond or preferred stock of equal quality paying equal interest or dividends.
The investment and conversion values are "floors" that support the price of the convertible. If the convertible's price dipped below conversion value, arbitrageurs would snap it up, or convert it and sell the common to make an instant profit. Similarly, if the price dipped below investment value, income-oriented investors would snap it up to get the conversion privilege for free.
How a convertible trades: It usually trades at a premium over both its conversion and its investment value. Investors may pay more than conversion value because the convertible pays higher income than the corresponding common stock. And investors may pay more than investment value because there is a chance that if the stock rises, the convertible's price will rise, too.
If you examine the price path of a convertible, you can see that at any point, the convertible will rise faster than it will fall. This, then, is favorable leverage; it follows that the convertible must have a better risk/reward ratio than the stock, for it will share in a greater proportion of any rise than in a decline.
Studies show that convertibles consistently outperform common stocks, over periods of five years or more. Why this should be so is best explained if we look at what happens in various phases of the market. When the market falls, it's easy to see that convertibles will do better. Not only do they fall less, but they also provide greater income. In a flat market, their greater income is the deciding factor. In a rising market, convertibles do not normally appreciate in price as fast as the common, but if the market rise is slow, the greater income from convertibles causes the total return from convertibles to equal or exceed the total return from common stocks. Only in a rapidly rising market, then, do convertibles fall behind. That convertibles have historically outperformed common stocks suggests what we already know, that stocks don't spurt upwards most of the time.
And finally: One of the most attractive features of convertibles, a feature pointed out by consultants to pension funds, is that a convertible portfolio will typically be less volatile than a portfolio of common stocks... which means that convertibles offer investors a more favorable risk/reward ratio than common stocks.
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posted by Bob Moser at
3:17 PM
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