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Key Risks and Rewards of Convertible Bonds

Convertible bonds, offering steady income like conventional bonds and potential capital gains like stocks, have gained popularity in recent years among investors seeking less volatile alternatives to equities. Mutual funds specializing in them have performed well so far this year, outpacing all other groups of bond funds and some stock funds. By some measures, convertibles have outperformed conventional bonds and stocks over the past 15 years.

But while these hybrid securities could be a good addition to your portfolio, you need to do your homework before investing, as convertibles are laden with several key risks and drawbacks.

Convertible bonds are like conventional corporate bonds in that they are issued by companies and pay a fixed rate of interest (their cousins, convertible preferred stocks, pay preset dividends). The interest yield will generally exceed the dividend yield on the issuer’s common stock.

The “convertible” feature means you can exchange the bonds for a set number of the issuing company’s common shares. Convertibles usually sell for a premium--typically around 25% for new issues--above the price of those common shares. When the price of those common shares rises to offset that premium, it may be advantageous to make the exchange.

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This convertibility feature results in the bonds usually rising in price when the underlying stock price rises. And if the stock price falls, convertibles generally won’t fall as much, because the interest payment acts as a cushion.

Hedging the Bet

As such, convertibles may be suitable for you if you aren’t convinced that stocks will go up but want to participate in case they do. They’re also attractive if you like bonds but want more protection against inflation.

“You’re making a hedged bet,” says Thomas Revy, managing director of Froley, Revy Investment Co., a Los Angeles advisory firm specializing in convertibles. “You don’t have the same agonies of inflation for bonds and recession for stocks. You don’t get beat up as bad in bad cycles for either type of instrument.”

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Convertibles also may be a safer way to play possible rises in small-company stocks--a group that many experts contend will outperform the stock market as a whole in the next few years, says John Rekenthaler, an analyst who follows convertibles at Mutual Fund Values, a Chicago-based investment advisory service. Because convertibles tend to be issued by smaller, faster growing companies, their prices tend to move with prices of those stocks, he says.

So far this year, convertibles haven’t disappointed. Mutual funds that invest in them were up 11.83% in 1988 through Sept. 30, according to Lipper Analytical Services, a Summit, N.J., firm that tracks fund performance. That compared to a 6.92% gain for fixed-income funds that invest in conventional bonds; it also topped average performances of all other fund groups investing primarily in bonds.

Growth Has Slowed

Over longer periods, convertibles are likely to outperform stocks and bonds, some experts contend. Lipper’s figures show convertible securities funds gaining 419.3% between 1972 and 1987, compared to 311.1% for the Standard & Poor’s 500-stock index (with dividends reinvested) and 223% for fixed-income mutual funds.

Reflecting their rising popularity in recent years, assets in convertible funds have grown to at least $4.4 billion from $595 million three years ago, Lipper says. (However, that growth has slowed, along with growth of other mutual funds, since the October crash.) The number of funds specializing in convertibles has risen to at least 33 from just 10 three years ago, Lipper says.

But the benefits of convertibles don’t come without a price. And buying individual issues can be very daunting.

Annual yields on convertibles, now generally ranging between 7% and 8%, are not as high as conventional corporate bonds. Furthermore, the premiums can be so high as to offset the yield. As a general rule of thumb, you don’t want to pay more than a 30% premium for a convertible yielding under 10%, investment adviser Revy suggests.

That’s because convertibles often carry “call” provisions that give their issuers the right to force you, after two or three years, to redeem the bonds at face value or convert them to common shares. That may not be enough time for the stock to rise enough to recoup the premium.

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So if a company’s stock is selling at $40, and the convertible is selling at the equivalent of more than $52 per share, you’re probably paying too much, Revy argues. (Convertible bonds typically are issued in $1,000 denominations. Thus, a $1,000 bond convertible into 20 shares of common stock is selling at the equivalent of $50 per share, making its premium $10 per share, or 25%, above the $40 stock price.)

Convertibles, just like other bonds, also can change in value when interest rates change, rising when interest rates fall and falling when interest rates rise. The worst scenario comes when interest rates rise and stocks fall--convertibles then suffer a double whammy.

Another drawback of convertibles: Low liquidity. The market for these securities is relatively small. So to buy or sell an individual issue, you may pay a broker a high commission (in the form of a “spread” between the price he will buy and sell it) amounting to between 2% and 5%, Revy says.

Lesser Grade

The low liquidity and small size of the market also contributed to a condition last year before the October crash when strong investor demand drove prices up to overvalued levels, Revy says. When stocks crashed, convertibles crashed too, losing about half to three-quarters as much as stocks, he says.

Finally, because convertibles tend to be issued by smaller companies, they usually are not considered “investment grade” by the major bond rating agencies. This lower perceived credit quality also contributed to last October’s declines as investors sold convertibles in a classic “flight to quality.”

With these and other risks and complications, you are much better off investing in convertibles through mutual funds. They reduce risk because they hold a diversified portfolio, and you don’t need to research each individual bond.

Rekenthaler of Mutual Fund Values recommends Dreyfus Convertible Securities Fund, a long-established no-load fund that he says has enjoyed an average annual compounded return of 14.2% during the past five years. The fund is among the more aggressive of convertible funds, typically investing two-thirds of its portfolio into convertibles and the rest in common stocks.

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For more conservative investors, Rekenthaler likes Lord Abbett Bond Debenture Fund, which has enjoyed a 10.2% compounded annual return during the past five years but with less volatility than the Dreyfus fund. It typically invests about one-third of its portfolio in convertibles, with the rest in conventional corporate bonds and cash.

Alternatively, consider so-called balanced funds or others that can invest more widely than pure convertible funds in stocks, bonds, money-market instruments and other alternatives, suggests Kurt Brouwer of Brouwer & Janachowski, a San Francisco money management firm.

“Convertible funds tend to put the portfolio manager in a straitjacket. He is stuck buying them at times when it is not advantageous,” Brouwer contends. Among these more diversified funds, Brouwer likes Mutual Shares, Evergreen Total Return and Fidelity Puritan.


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