Buyers of fixed-income securities should be aware of a hybrid, investment instrument, the convertible bond. It is hybrid, because it possesses characteristics of a fixed-income security -- a coupon and a maturity -- but it also has the characteristics of an equity in that the bond is convertible into a specified number of shares of common stock, and tracks the price movement of the stock as well. The convertible market is mostly an institutional affair, with the participants being broker-dealers, money managers and various types of institutions. Wealthy individuals may become involved, either directly or through mutual funds or trust departments.
The key to understanding convertibles is to have a working knowledge of the terms. Beside having a coupon and a maturity, the convertible has other important parts. The first is the number of shares into which a $1,000 bond is convertible. That factor will remain constant. The next is the price of the common stock at any given time. Then there is the "conversion value," or parity value, which is found by multiplying the number of shares by the price of the common stock. The parity is the value of the bond without the premium. The price of the common and the parity change constantly. Finally, we have the actual price of the bond as it trades in the market.
In putting all these factors together, let's suppose we have a bond with a 7 percent coupon due June 6, 2010, selling at $1,000 (par) a bond. The bond is convertible into four shares of common, and the common currently is selling for $20 a share. The parity value will be $80 -- (4 x $20). Subtracting the parity value ($80) from the price of the bond ($100) gives the amount of premium paid ($20), or 20 "premium points." Dividing the $20 premium by the $80 parity gives the percentage of the premium (25 percent). Assuming that the common stock pays no dividend, and therefore has a zero yield, we can divide the percentage of the premium (25 percent) by the current yield on the bond (7 percent) and calculate the amount of time it takes to break even, or to make up the premium paid, with the current yield (income). In our example, the break-even time will be 3.57 years (25 percent divided by 7 percent). The percentage of the premium also may be derived in dollars, in which case the calculation for the break-even period will be different.
Why a convertible bond? Two answers: for the yield and as a defensive play. In many instances, a growth stock may be returning next to nothing, while the average yield on a new convertible may fall between 8 and 11 percent. A convertible is a defensive mechanism, in that the yield on the bond is greater than the stock and also because the bond tracks the price movement of the stock, but at a slower pace. If the stock should fall 5 points, the bond may decline only 1 point.
Some other points: A favorable outlook for a stock should be the foremost reason for purchasing a convertible. Also, for an individual, amounts under $50,000 could have a 1-point spread between the bid and the offered side of the market. An individual also will pay a commission of $2.50 a bond if purchased or sold directly with a broker rather than through an institution. Finally, convertibles represent subordinated debt, and in many instances will carry credit ratings below single A. In fact, most converts are rated BBB or lower. This means that individuals should do their homework on the merits of the stock and exercise caution in buying the bonds. With the right stock and a good market, convertibles can be rewarding.