Investors who get woozy from the ups and downs of the stock market may find the ride a little more relaxing with convertible securities. The conventional convertible security is a preferred stock, or debenture (bond), that is convertible into common shares. It's designed for people who want more income than they would get from the common stock while, at the same time, participating in the common stock's performance.
Consider ABC common stock, which is selling at $15 per share and paying a $.25 annual dividend. That's only a 1.67% yield. Suppose the company has a bond selling at $1,000, paying $50 of annual interest and convertible into 50 shares of common stock. Which would you rather own: the common stock or the convertible bond? It would cost you $1,000 to get 50 common shares by purchasing the debenture and converting it, which is $250 more expensive than the $750 cost of simply buying 50 shares outright at $15 per share. However, as long as you hold that bond, you'll be earning $50 per year in annual interest, whereas 50 shares of common stock would only pay you $12.50 per year based on the $.25 dividend. That's an extra $37.50 per year in income. So, after 6.67 years of holding the debenture, you'll have received $250 more income than you would have received from the 50 shares of common stock. You will thereby have recouped the $250 extra that it cost you to buy the 50 common shares through the debenture rather than simply buying them outright. The amount of time that it takes for that to happen is referred to as the "break-even period."
Another way to calculate the break-even period is to divide the percent premium at which the convertible is selling relative to its conversion value by the difference between the yield of the coupon to conversion value and the yield of the common. In this example, the $1,000 debenture sells at a 33.33% premium over its $750 conversion value. The $50 coupon would yield 6.67% based upon the bond's conversion value, which is 5% more yield than the 1.67% yield on the common stock. The break-even period is thus 33.33% divided by 5%, which is 6.67 years. Investors in convertible securities want low break-even periods - that is, they don't want to pay a big premium-to-conversion value and they do want to get a lot more income than they would get by simply owning the common.
In addition to providing more income, a convertible security also tends to be less volatile than its underlying common stock. This is because the convertible security has more yield protection. For example, let's say that the price of ABC common stock in the above example gets cut in half but the dividend remains the same. Even then, the stock will only be yielding 3.34%. But the price of the convertible bond should hold up better. It's not likely that the market would drive the bond price down to half its original value because the yield would likely then be significantly above other market yields. In this case, the yield would then be 10%, and the yield-to-maturity would be even higher, at 15%, if the bond had ten years left until maturity. Also, interest paid on a convertible bond is more secure than the dividend paid on the common stock.
There is, however, one trade-off. A convertible security doesn't tend to increase in value as much as common stock might. As common stock appreciates, a convertible bond also appreciates, but the appreciation of the convertible bond is dampened somewhat because the premium-to-conversion value shrinks in tandem with the convertible bond's shrinking yield. Still, the convertible investor shouldn't mind because he's received what he asked for - participation in the common stock's rise and an increased income stream.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.