From the May 1997 issue of Entrepreneur

Summertime, and the investing is . . . well, anything but easy. After months of record-breaking highs, the stock market's "irrational exuberance" has made many investors more cautious. And yet, who doesn't long for those starlit nights around the campfire, spinning tales of profits made and capital gains taken? Well, if you want to have your gains and protect your investment, too, you can find a measure of both credit safety and potential appreciation in convertible bonds.

Convertible bonds are hybrid securities that share characteristics of both stocks and bonds. As the name implies, these securities can be exchanged for a set number of shares of the underlying common stock, and their price tracks that of the stock on the way up. But as fixed-income securities, they pay a fixed interest rate like a regular bond. These interest payments cushion the bond's prices when the stock declines, so convertible securities rarely fall as far or as fast as their common stock cousins. For some investors, convertibles provide the best of both worlds.

Investing With The Top Down

Investors have the potential to earn money with convertibles in several ways. First, the bonds pay income to investors at a fixed rate, like a traditional bond. Second, convertibles can appreciate in value and may result in a gain when the investor sells them. Finally, the bonds can be converted into shares of stock, if the price has risen enough to justify the conversion, and the stock can then be sold for a gain.

Of course, like any security, a convertible bond's price can also decline in value. For all this flexibility, investors pay a premium and earn less interest than they would on a conventional bond. Convertibles also offer comparatively less security than straight bonds because their price is more volatile since their value is linked to the price of the underlying common shares. Unlike conventional bonds, convertibles are debentures--unsecured debt instruments--and therefore are often of lower credit quality then the company's other debts.

Convertible bonds are long-term debt instruments and have features common to all bonds. They usually sell in $1,000 denominations, pay interest semiannually and have a fixed maturity date. Like many bonds, they are callable, but the big difference is their ability to be changed into common stock . . . abracadabra!

Many convertible bond investors track the issuer's common stock, having purchased the bonds to be able to participate in the equity market with some downside protection. However, these bonds are not suitable for everyone, as they require knowledge of several complex factors. So before you decide to take a ride down Wall Street in a new convertible, here are a few things to know:

1. Investment value: The convertible's value as a traditional bond is known as its investment value. Investment value is determined by comparison with the price of a regular bond whose interest payment, credit rating, maturity and issuer are similar. Keep in mind that convertibles often have a higher price then comparable bonds, and because of their extra features, normally yield less than similar nonconvertible bonds.

2. Yield advantage: Convertibles often have higher current yields than common stocks that pay dividends. To calculate the yield advantage, subtract the current yield on the dividend-paying common shares from the higher convertible yield.

3. Conversion price: This is the specified price per share at which the convertible could be converted into common shares. This information is found in the convertible's legal description, and the information should be available from your financial advisor. If the underlying stock splits, conversion prices are usually adjusted.

4. Conversion ratio: This is the number of common shares resulting from the division of the face amount of the convertible by its conversion price.

5. Conversion value: What the convertible is worth as a stock at current market price is known as its conversion value. Multiplying current share market price by the conversion ratio indicates a convertible's conversion value. Conversion value rises and falls with common share price.

6. Conversion premium: The percentage difference between a convertible's actual market price and its conversion value is called the conversion premium. The lower the conversion premium, the closer the convertible is to its value as a common stock.

7. Break-even period: This indicates how quickly the yield advantage is created by a convertible's higher current yield, relative to the current common stock yield. To calculate the break-even period, divide the conversion premium by the yield advantage.

At first glance, understanding these terms and their assorted permutations may seem like an exercise in futility, sort of like trying to replace the head gasket on your 1965 Mustang when you don't even know how to change the oil. But if convertibles are something you'd like to add to your portfolio, you've got to get a little dirt under your fingernails.

The Road To Success

As anyone who has ever owned a convertible can tell you, you've got to have a provision for those rainy days. So before you invest, make sure you know when the bond is callable. If it is called early, you may not get the chance for appreciation to repay you for the premium you paid. And never buy a convertible unless you like the underlying stock. One way to find a good convertible is to compare it with other issues in the industry.

Before embarking on a buying spree, John Carroll, first vice president and manager of convertible trading at Prudential Securities in New York City, suggests looking at more recent models. Carroll notes that convertibles issued several years ago may have already appreciated along with their stock. If the underlying stock has risen 50 percent, the bond may have already appreciated 40 percent. If the stock falls, the bond could be subject to the same kind of volatility. "Instead," suggests Carroll, "buy convertibles selling near par in stocks you otherwise like. If the stock goes up, you will participate [in the profit] because you own the convertible, but if the stock drops, you have less downside risk."

Check under the hood before buying, and kick the tires of the underlying company, too. Because convertible bonds are subordinated debentures, it's especially important that the issuer has a strong balance sheet. That way, you know you'll receive your interest payments in a timely manner.

Speculation is possible as well, in the form of lower-quality, higher-yielding bonds whose risk of default is higher. Ask your mechanic--I mean financial advisor--his or her opinion. Finally, consider buying bonds from larger issues so illiquidity won't become a problem if you decide to sell or want to buy more in the secondary market.

Other Models

So far we've looked at just convertible bonds, but there are lots of other types of convertible securities you might want to consider before you buy. In addition to convertible bonds, some companies issue convertible preferred stock. Like convertible bonds, convertible preferred stock is a hybrid security that has some of the same characteristics of nonconvertible preferred stock. It, too, is usually callable, and its conversion value characteristics are similar to those of convertible bonds. The major difference is that while convertible preferred stock trades at a premium over both standard preferred and common stock, the premium is smaller than that of a convertible bond over the common.

Taking A Spin

Convertibles, like most securities, should be part of a diversified portfolio. In some cases, even after you've mastered the ins and outs of how to buy individual issues, you may not want to spend the time to follow them, or may not want to make the minimum investment necessary--around $10,000 for an individual issue.

Some investors feel uncomfortable about putting all their eggs into one investment vehicle. Fortunately, there are lots of options. Convertibles come packaged in diversified, professionally managed portfolios, either by themselves or with other securities. This way, you can let someone else worry about conversion premiums and call dates.

Before you invest, read the prospectus to be sure you understand how the bonds will be managed and the manager's objectives. Open-end funds (which offer professional management and diversification but trade on an exchange) are also available. In both cases, remember that past performance is no indication of future returns. Whatever road you decide to take, happy cruising!

Contact Sources

Jerald Melberg Gallery, 3900 Colony Rd., Charlotte, NC 28211, (704) 365-3000.

Lorayne Fiorillo is first vice president of investments at Prudential Securities. She presents retirement planning and personal finance workshops worldwide. For more information, write to her in care of Entrepreneur, 2392 Morse Ave., Irvine, CA 92614.