Convertible Bonds Get New Attention

Convertible bonds have been getting a fresh look this year from investors who may like a company’s prospects but are fearful of the volatility of its stock.

Especially in the technology sector, “this is the chicken’s way of investing,” notes Anand Iyer, head of global convertible bond research at Morgan Stanley Dean Witter in New York.

“For people who need the income . . . or who are just scared of volatility in tech stocks but know they need exposure to the new economy, convertibles are a decent way to go,” says Michael Murphy, editor of the California Technology Stock Letter and manager of the Monterey Murphy Technology Convertible fund.

What exactly are convertibles?

A convertible bond is a corporate debt issue--in effect, an I.O.U. typically maturing in five to 10 years--that can be converted by the investor into a preset number of the company’s common shares before the bond matures. Hence the name.

By tacking on the conversion feature as a potential “sweetener,” companies can generally get away with paying a lower interest rate to raise funds via convertible debt than through conventional bonds.

For investors, the conversion feature offers a way to play some of the upside potential in the underlying stock, because the bond’s value naturally should track the stock’s market price to a large degree.

At the same time, the fixed-income feature can provide a buffer for the bond’s value if the underlying stock dives, dashing the value of the conversion feature.

Technology companies in particular have become major issuers of convertibles: More than a third of convertible debt outstanding is from tech firms.

Some conservative investors would never buy a high-risk tech stock, most of which pay no dividends. But a tech firm’s convertible bond--yielding from 3% to 7% in annual interest, depending on the issuer--may have appeal even for risk-averse investors.

This is particularly true now, said Ravi Malik, senior portfolio manager at Froley, Revy Investment Co., a Los Angeles-based money manager that specializes in convertible securities.

“Some of these tech companies have tremendous growth prospects, but also have high stock P/Es [price-to-earnings ratios] for the same reason,” Malik noted.

With market interest rates on the rise this year, prices of many high P/E stocks have been under pressure. Convertible bonds, Malik says, at least offer the prospect of interest income even if the stocks temporarily stall or decline.

Perhaps not surprisingly, the average mutual fund that invests in convertible bonds has delivered a total return (interest income plus price gain) of about 10% year to date, according to Morningstar Inc. That’s better than the 9.7% return on the Standard & Poor’s 500 stock index.

In the last three years, however, the average convertible fund’s return has been 13.2% annualized, well below the S&P;’s return.

But for many investors, volatility matters as much as return.

A recent Merrill Lynch study of 135 tech convertible bonds and their underlying stocks found that since Dec. 31, 1994, the convertibles have delivered 70% of the total returns of their underlying stocks.

Meanwhile, the convertibles provided considerable downside protection: In the 16 months since 1994 in which the tech stocks on average declined in value, the convertible bonds fell less sharply--or rose in value--in 15 of those months.

In August 1998, for example, the tech stocks slid 21.6% as a group, according to Merrill. The convertibles tied to those stocks lost about half as much (11.2%) that month.

Because of convertibles’ potential for downside protection, some analysts argue that they make an intriguing way to play Internet stocks. And many Net companies have issued convertibles over the last year, including such names as Amazon.com, DoubleClick Inc. and CNet Inc.

But analysts caution that investors still must take into account a bond’s credit-worthiness. Merrill Lynch convertible analyst Anne Cox notes that “because of the generally weak credit [ratings]” of Internet firms, the “floor” under the bonds’ values may be quite low should trouble hit.

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Any investor looking at convertible bonds should first understand how the securities are priced in the market.

Consider the convertible bond issued by San Jose-based software firm BEA Systems. Recently, the bond, which matures in June 2005 at its par value of $1,000, has been trading at a price of $1,258.

Is that a fair price? To determine that, an investor must first calculate the bond’s “conversion premium,” or the excess of the bond’s value over how much the security would be worth if it were converted immediately into BEA stock.

Each BEA bond is convertible into 37.8698 shares of common stock at the investor’s discretion. The stock closed Monday at $30.06 a share. So each BEA bond is now worth $1,138.37 in BEA stock.

Why is the market pricing the bond at $1,258, or 10.5% more than the current value of the underlying stock? In part that reflects the bond’s interest return: Its current annualized yield is 3.2%, whereas BEA stock pays no dividend.

By dividing the “conversion premium” of the bond--the extra 10.5% value--by the bond’s annual income return, you get something called the “payback period.”

In this case, 10.5% divided by 3.2% is 3.3. This is a back-of-the-envelope method of figuring out how many years in theory you’d have to hold the bond to recoup the extra money (conversion premium) you’re paying for it.

Of course, the underlying stock value will fluctuate. But a rule of thumb, analysts say, is that a convertible that pays you back in about three years or less is considered an attractive risk.

Also, in general, bonds with conversion premiums of 25% or less are considered “equity sensitive” or “in the money”--meaning the bond should capture most of any upside in the stock from that point, notes Ed Cassens, manager of the Nations Capital Income fund.

Bonds with conversion premiums of 40% or more, by contrast, are generally more bond-like, meaning they should capture less of any further upside in the stock, because much of that upside may already be factored into the bond’s value.

In any case, as long as the company remains financially healthy and able to pay its debts, the bond’s long-term downside should be limited by the expectation of being paid back at $1,000 par value at maturity.

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For investors, a professional’s help may be essential in picking individual convertibles.

“You have to do more homework here than in other areas of investing,” said Murphy of the California Technology Stock Letter.

For starters, note that many convertible issuers are smaller firms. “There aren’t a lot of big-cap, blue-chip growth stocks that need to raise capital through convertibles,” said Nick Calamos, manager of the Calamos Convertible and Calamos Growth & Income funds.

Also, most convertible bonds are “callable,” which means the issuing company can redeem the debt at cash par value before maturity. Knowing the call feature of a bond is crucial.

The easiest route for many investors who like the idea of convertibles is to invest through a mutual fund. There about 30 such funds. You can research them at Morningstar’s Web site: https://www.morningstar.com.

For data on individual convertible bonds, try the Value Line Convertibles Survey. In addition to raw data, Value Line’s weekly publication supplies buy, sell and hold recommendations on more than 600 individual convertible securities. A one-year subscription: $525. For more information, call (800) 535-8760, or visit Value Line’s Web site, https://www.valueline.com.

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Paul J. Lim can be reached at paul.lim@latimes.com.

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Some Hot Convertibles

Convertible bonds--debt securities convertible into common stock--offer a way to play the stock market while enjoying an income buffer. Shown here are six convertible mutual funds that have above-average exposure to the technology sector and that during the last three years have posted above-average total returns with average or below-average risk, according to fund tracker Morningstar Inc. Total return includes income yield plus or minus principal change.

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3-year Total return: annualized 12-mo. 800 phone Fund YTD* 1-year return yield Pilgrim Convert 14.3% 38.2% 21.2% 1.7% Calamos Growth 15.6 30.7 16.8 2.5 Fidelity Convert 12.9 29.8 16.8 3.0 Davis Convert 7.8 17.5 15.7 3.0 Nations Cap Income 10.5 23.7 15.3 2.7 Van Kampen Harbor 15.7 34.5 14.7 3.2 Avg convert fund 10.0 21.6 13.2 3.3 S&P; 500 index 9.7 32.8 26.9 1.3 Avg US stock fund 8.9 31.6 17.7 0.8

Fund number Pilgrim Convert 334-3444 Calamos Growth 823-7386 Fidelity Convert 544-8888 Davis Convert 279-0279 Nations Cap Income 321-7854 Van Kampen Harbor 421-5666 Avg convert fund S&P; 500 index Avg US stock fund

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* Year to date

Sources: Morningstar Inc., Times research