Preaching to the Convertible

By Russ Wiles

Nov. 4, 1997 12 AM PT

Russ Wiles is a mutual fund columnist for The Times

Spokane, Wash., may be an unusual place from which to run a mutual fund, but that’s where you will find Ed Cassens, portfolio manager of Pacific Horizon Capital Income.

Cassens invests in convertible bonds and convertible preferred stock, which he says make ideal investments for people who are a bit nervous about the stock market. These securities can be converted into or exchanged for a set number of shares of an issuing company’s common stock, assuming those shares rise to a target level. (Convertible bonds are indicated with a “cv” in the yield column of The Times’ Saturday bond tables.)

Some observers would say convertibles are the worst of both worlds--lower yields than other corporate bonds and less appreciation than the common stock they are convertible into. But others see it differently--convertibles are better than regular bonds because they can be converted to stock if prices rise, and they’re safer than regular stock because of the income they pay out.

Essentially, convertibles allow investors to participate in at least some of a stock’s appreciation while earning income. With a fund of convertibles, then, individual investors get a yield that is an average of what the convertibles in the portfolio are paying (minus fees, expenses, etc., of course).

The Pacific Horizon fund, currently yielding a bit more than 3%, ranks as one of the big fish in the small pond of convertible bond funds. It places among the top 10% of funds in its category over the last one, three, five and 10 years, according to fund tracker Morningstar of Chicago.

Cassens can’t claim all the credit for the long-term record, since he has been at the fund’s helm only since August 1994. But for the period of his tenure, the fund, with its three-year average annual return of 21.4%, handily outpaces the performance of the average convertible-bond fund.

Cassens, 57, oversees $700 million in convertible-bond assets for his employer, BankAmerica Capital Management. He is a native of Walla Walla, Wash., and has degrees from Washington State and Gonzaga universities. Cassens was interviewed by Russ Wiles, a mutual fund columnist for The Times.

Times: Your fund focuses on convertibles but doesn’t include that word in its name. That must mean you have leeway to invest in other things.

Cassens: Yes. We can hold up to 25% of the portfolio in stocks or government bonds. Right now, I have nothing in government bonds and 8% in stocks. Everything else is convertibles. Before I became manager, “convertibles” was dropped from the name because few people knew what they were.

Times: So give us the two-minute drill on what convertibles are.

Cassens: These are securities, either bonds or preferred stock, that are convertible into the issuing company’s underlying stock, usually at a price 20% to 25% above the existing price. Companies issue convertibles because they want to sell stock at that higher price. Investors don’t convert [i.e., trade for common stock] until the stock hits that price. In the meantime, companies are able to raise cash by issuing the bonds, which allows them to deduct the interest expense. And they pay less in interest expense on convertibles than they would by issuing straight bonds.

Times: What’s in it for investors?

Cassens: For starters, convertibles yield more than the underlying stock, assuming it yields anything. Also, convertibles will drop less in price than the underlying stock, so there’s downside protection in case of a bear market. We think of our convertible fund as providing “equity with training wheels.” The bank started this fund for people who were getting out of certificates of deposit for the first time, who had never invested in stocks before.

Times: So convertibles trade like bonds during rough stretches in the stock market and like stocks during good times.

Cassens: Exactly. They will drop less than the underlying common stock. It’s not uncommon to see convertible bonds go down only about one-third as much as the company’s stock yet rise about two-thirds as much when the stock rallies . . . these investments provide a lot of protection. For example, when large-cap stocks dropped about 5% in August, my fund slipped about 0.5%. That put us roughly even for the year against the Dow and Standard & Poor’s 500, because we had been lagging by 4% or 5% before then.

Times: What sort of companies issue convertibles?

Cassens: The traditional issuer is a small, rapidly growing company. Technology firms stand out because they have such a need for capital. You also can find issues from biotech, retailing and energy companies. One attraction for selling convertible bonds is the lower coupons [interest rates] that firms pay compared to straight bonds. Eventually, they want to build up equity on their balance sheets by selling stock at a higher price than the current price. The typical issuer has a B or BB credit rating, which means these are not investment-grade companies. But I don’t call them junk-bond issuers because there are many fine companies that started this way. Starbucks is a good example. When it issued its first convertible, it was a low-rated company. It’s not up to investment grade yet, but most people would agree that it’s not a junk firm.

Times: So do convertible funds make sense primarily as stock market plays for conservative investors?

Cassens: Yes. They behave a lot like equity-income funds, but with even more downside protection. When you drop only about one-third as much on the downside while gaining two-thirds as much on the upside, you are less volatile by definition. The long-term return on convertibles has roughly equaled that of the S&P; 500, with about 30% less volatility. That’s not supposed to happen. It’s like a free lunch.

Times: It does sound like a good deal. So how come more people don’t know about convertibles?

Cassens: We tend to get lost in the shuffle because convertibles are a small segment of the domestic bond market, representing only about $120 billion. Also, remember that when the underlying stock goes up, these bonds are converted into stock. If everything works out, a bond might be around for only about three years. So while you constantly see new issues coming out, others are being redeemed. It’s hard for the market to grow in size compared to straight corporate or municipal bonds, where issues remain outstanding for longer.

Times: How do you analyze convertibles?

Cassens: They are labor-intensive, because the characteristics of convertibles change as the price of the underlying stock changes. You have to constantly analyze them to see how they fit in your portfolio. We take a top-down approach, looking at the economy and asking what industries we want to emphasize. Once we identify an industry we like, we see what’s available in terms of convertibles.

Times: Generally speaking, are convertibles attractive at the moment?

Cassens: Both the overall stock market and convertibles have a lot of risk. That’s because the market has been so strong, pulling convertibles up in price. New issues tend to be more attractive than existing issues, because they haven’t had a chance to run up in price. But in general, I’m nervous.

Times: Yet you said Pacific Horizon portfolio is nearly fully invested in convertibles right now.

Cassens: Yes. We tend to run fully invested.

Times: Could you cite a couple of examples of convertibles that you like?

Cassens: I have been emphasizing finance, technology, health care and, lately, oil well service companies. In the latter area, one favorite is a convertible issued by Loews Corp., which owns 50% of Diamond Offshore. This bond is convertible into the underlying stock of Diamond. It’s an A-rated bond with a 3.13% coupon due in 2007, selling for about 110 as a percent of par [or an actual price of $1,100 for a face value of $1,000]. As I mentioned, it was issued by Loews but is convertible into Diamond stock, so we consider it a Diamond convertible because it moves as the Diamond stock moves.

Another favorite is Sovereign Bancorp preferred. . . . Sovereign is a financial holding company that possibly could be taken over. In the finance area, there’s still a lot of potential for takeovers and consolidation.

Another holding is the preferred stock of H.F. Ahmanson, which recently announced a merger with another California company [Coast Savings Financial, parent of Coast Federal Bank].

In the health area, we own Dura Pharmaceuticals bonds. Dura is a fast-growing company that serves specialized niches in the pharmaceutical area. It has a good record, good management and good prospects.

[The Sovereign and Ahmanson issues are convertible preferred stock, rather than bonds, so they don’t have maturity dates but are callable by the company beginning in 1998.]

Times: Speaking of pharmaceuticals, your top holding, Warner-Lambert, is a common stock.

Cassens: I added drug stocks when I took over the portfolio in 1994. Back then, the Federal Reserve had been boosting interest rates, so I was worried about an economic slowdown in 1995. I felt the drug companies would be immune to that, from the way their sales tend to go up year in and year out. I also knew Warner had some big drugs coming out. I still like the stock. I also own Bristol-Myers Squibb, American Home Products, Schering-Plough and Colgate-Palmolive, all as common stocks.

Times: As for convertibles, it’s hard not to notice that your picks have maturities of 10 years or less.

Cassens: Convertibles tend to be intermediate-term bonds. Most are sold with seven- or 10-year maturities. That’s good because if interest rates shoot up, these bonds won’t drop much.

Times: Are convertibles a type of investment that individuals can tackle on their own? Or are they so specialized that a mutual fund makes more sense?

Cassens: Individuals can invest in these on their own, but there are some reasons you might want to use a fund. As a company’s stock and bond change in price, the characteristics of the convertible change.

One tends to do a lot of trading with convertibles. Also, if things work out right and the issue is called, you’ll face a change in your portfolio. So there’s more than normal turnover. Some convertibles aren’t even available to individuals. . . .

And, as I mentioned, convertibles involve more work.

For more information: A leading source of information on convertibles aimed at individual investors is the newsletter Value Line Convertibles ($625 a year; shorter periods available); call (800) 634-3583.

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Pacific Horizon Capital Income

Strategy: Seeks capital appreciation and income by investing in convertible bonds and convertible preferred stocks.

VITAL STATISTICS

12-month total ret., through Sept. 30: +33.4%

12-month ret., avg. conv. fund: +24.1%

3-year annualized return: +21.4

3-year annualized ret., avg. conv. fund: +16.9

5-year annualized return: +18.9

5-year annualized ret., avg. conv. fund: +14.2

Five biggest holdings as of Sept. 30:

1. Warner-Lambert