The Convertible Craze Brightens The Future Of Equities
Convertibles are stealing the show with their safe investment image in today’s “protective” market. They seem to be overshadowing the stocks and bonds, and this holds true for the mediocre issuers.
A convertible bond, as the name suggests, can be converted into a company’s common stock. The bonds are a source of additional profit for the investors. Although investors are particular about short-term performance of stocks, they’re upbeat about a long-term, fixed-income instrument that gives them profit on converting to common stock, if the stock price soars within a range of 20 to 40 percent.
Why the sudden craze for convertibles? The chief reason is the strong desire of the investors for “safe” instruments to lock up their precious life savings into. And the issuers have been smart enough to grab this lucrative opportunity. A few years back, liquid issuers—considered to be the stalwarts of the market—were ruling the roost in the convertible bond market, with the average size of a convertible issue touching $300 million to $350 million. But today, nearly nine convertibles have a whopping size of $1 billion and one has even crossed the $3 billion mark. The fall in stock prices and the frequent quivers in the credit markets have created a strong wave of demand for convertibles.
A convertible bond is issued at a strike price, 25 to 40 percent higher than the market price of the general stock issued by the company. The convertible bond has a 7-year maturity period and can be called after three years. The issuer can call the bond, if the market price exceeds the strike price. But if the strike price manages to remain high till maturity, the investors have two options: they can either get back the par value of the bond, or convert it to common stock. However, in case of a mandatory convertible, there is no choice—the bond has to be converted to common stock.
Convertible bonds are legally debt securities, which are above all equity securities in a default situation. Similar to other bonds, their value is also influenced by the existing interest rates and the credit worthiness of the issuers. However, convertibles have opened two ways for the investors to earn dollars. One way is by selling the convertible bond when its price soars in the market, and the other way is by converting the bond to common stock and selling the shares.
The best way for an individual investor to indulge in the convertible bonds business is buying a mutual fund. This is because convertibles are complex securities and, unlike common stocks, it’s not easy for beginners to get all the information about them. Hence, the investors should check out certain things before buying a convertible bond. These are: the interest rate and yield of the bond, the number of years prior to maturity, the common stock price during conversion of the bond, the features of the bond that make it different from a usual bond, the negative aspects of the bond, and the benefits while converting to a common stock.
Besides this, the investors should also inquire about the company that is issuing convertibles. Any bond, either convertible or the general one, is a loan. Hence, the investors should ensure that their issuer has the capability to pay back what they owe. Therefore, going for a convertible bond demands an extensive homework on the part of the investor.
When we compare convertible bonds to convertible preferred stocks, the former are safer. There are two reasons for this: the interest on convertible bonds is paid before any stock dividends, and, if the company suffers a loss, the investors of convertible bonds have an upper hand over the investors of stocks while claiming the money.
However, it’s not prudent to get carried away by the benefits of convertibles. Firstly, convertible funds happen to be costlier than domestic stock funds, as the former come packed with sales charges. Secondly, a majority of the convertibles are issued by companies involved in technology and telecommunications, which are characterized by unpredictable markets. And lastly, convertible bonds don’t guarantee a risk free investment just because they are convertible.