This is the age of the convertible. Not the sporty, top-down runabouts that people love to drive in warm weather, but the convertible security that offers investors a chance to diversify their holdings and reduce the risks that come with owning stocks.
Convertibles offer advantages and disadvantages for investors and for the companies that issue them. But, in recent years, a growing number of Washington-area firms have latched onto convertibles as a quick, easy and relatively inexpensive way to raise money for their businesses.
Some of the area's best-known names are on convertibles. They include Perpetual Savings Bank, Federal Realty Investment Trust, Hechinger Co., Atlantic Research Corp., Legg Mason and Farm Fresh.
A new name, Columbia First Federal Savings & Loan of the District, was added last week. Washington Homes of Waldorf, Md., will join the list in a few weeks.
Convertibles come in two varieties: the convertible corporate bond, usually called a debenture, and the convertible preferred stock. Of the two, the bond is more popular.
The convertible bond is sold in $1,000 face-value amounts. It carries a fixed interest rate and has a set maturity. Convertible bonds issued recently have offered rates ranging from 7 percent to 7.5 percent and maturity dates 20 to 25 years in the future.
Convertible securities are so named because they can be converted into shares of a company's common stock at the option of the investor. Under certain circumstances, the convertibles can be redeemed by the company before maturity.
In a recent study, Eliot H. Benson, research director of Ferris & Co., called convertibles "an attractive investment alternative" and said they could provide investors with several benefits.
"The yields from these securities are usually higher and more predictable than those on common stocks" and "provide some of the benefits of fixed-income securities while allowing an investor to participate in a stock market advance," Benson said.
In a rising stock market, Benson noted, as the price of a company's stock goes up, the price of its convertible also is likely to rise. The investor can benefit by converting his bond into stock or by selling the bond.
If stock prices fall, the investor is partially protected because the built-in interest payment will cushion the decline in the market price of the convertible.
Quite clearly, convertibles are more complicated than stocks or bonds, and an investor who is interested in them should consult with a stockbroker or other financial adviser.
But there are a couple of things an investor generally can figure out for himself.
To begin with, the bonds are convertible to shares of stock at a set price.
Three steps will tell you how to calculate their relative values.
Step 1. Divide the face value of the bond, $1,000, by the price at which you can convert. If the conversion price is $40 a share, you can get 25 shares when you convert.
Step 2. Multiply the current market price of the common stock by the number of shares you can get on conversion. For instance, if the common stock is selling for $30, the 25 shares are worth $750.
Step 3. Compare the selling price of the convertible bond to the $750 value of the 25 shares. If the bond costs $1,000, the bond is selling for 33 percent more than the bond's $750 conversion value. This is called the premium.
"In a sense," said Benson, "this is an insurance premium for the convertible's higher yield and protection in a declining market."
The premium, said Benson, tends to narrow when the stock price rises. It tends to widen when the stock falls because the insurance feature is all the more valuable.
What yardsticks should an investor use when looking at convertible bonds?
First, Benson said, an investor should be confident that the company's prospects are good, that its shares are reasonably priced and appear likely to rise in value over time. Second, the yield on the convertible bond should be significantly higher than the yield available from dividends on the stock.
Third, the premium should be in line with premiums on similar convertibles and should reflect the company's prospects. Fourth, the bonds should provide the investor with several years of protection against the company's calling in the bonds.
Newly issued bonds usually include a two- or three-year waiting period before a company can redeem the bonds. Investors looking at older convertibles may find that the waiting period has expired.
Using these yardsticks, Benson recommended the convertibles of three area companies:
Perpetual Savings of Alexandria, a $4 billion thrift institution that operates in the District, Maryland and Virginia. The fixed rate of interest is 7.25 percent, the bond matures in 2011 and the conversion price is $37.75 a share. It currently sells at $105 ($1,050) to yield 6.9 percent. Its current price is 24 percent higher than its conversion value of $847.68.
Federal Realty Investment Trust of Bethesda, which invests in community shopping centers. The fixed rate is 8.75 percent, maturing in 2010, and the conversion price is $16 a share. It currently sells at $121 ($1,210) to yield 7.2 percent. That price is 2 percent higher than its conversion value of $1,187.50.
Farm Fresh of Norfolk, a 34-store supermarket chain that is expected to acquire Open Air Markets in a $41 million deal. Its fixed rate is 7.5 percent, maturing in 2010, and its conversion price is $25.25 a share. It is selling at $92 ($920) to yield 8.2 percent. That is 66 percent higher than its conversion value of $554.40.
The 66 percent gap between the price of the convertible bond and the value of the bond when converted into shares of stock, Benson said, reflected a temporary drop in the price of Farm Fresh shares. He said he expected the shares to rise eventually as a result of the forthcoming merger.
Although the price of Farm Fresh shares fell, Benson noted, the convertible bond offered investors protection on the downside. As the price of the bond dropped, the yield increased to 8.2 percent, thereby helping to stabilize the price of the bond.
The newest convertible bond to be issued in the area is by Columbia First Federal Savings & Loan Association of the District.
The thrift sold $25 million in bonds that pay 7.5 percent interest for 25 years. They can be converted to shares of Columbia First stock at a price of $21.50 a share. A bond holder thus would get 46.51 shares on conversion. At $17.50 a share, that's a total value of $813.93. Thus the bond, priced at $100 ($1,000), was selling at 22.9 percent above its conversion value.
The company can't call the bonds for three years.
Columbia First had considered the possibility of a second stock issue but decided to sell the debentures. Some companies find it is less expensive and faster to do a convertible issue than a stock issue. There is also less paper work involved.
The $25 million issue is Columbia First's second major fund-raising effort. The thrift took in $24 million on its first stock issue when it went public last fall at $10 a share.
The stock closed Friday at $17.50, up 75 percent in eight months.
Dewitt T. Hartwell, president of Columbia First, said the chance to borrow $25 million at a 7.5 percent interest rate was "too attractive to turn down. It was an opportunity I didn't want to pass by."
Merrill Lynch analysts expect a number of electric utility stocks to outperform the market in general for the intermediate term. One of the utilities they recommend for "yield plus potential growth" is Dominion Resources of Richmond, selling at $45.25 on Friday. Dominion will earn an estimated $3.60 to $3.80 in 1986 and $3.80 to $4 in 1987, with an indicated dividend of $2.84 and an indicated yield of 6.6 percent, the analysts said.
Have you heard this one? Two stockbrokers met on the corner of 19th and K last week. Broker Jones thought broker Smith looked terribly tired and asked, "With the market falling so fast, are you having trouble sleeping at night?"
"Oh, no," broker Smith replied. "I sleep like a baby. Every three hours I wake up and cry."