Cruise Control If you're looking for gains plus protection, consider the flexibility of convertible bonds.

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 morecautious. And yet, who doesn't long for those starlit nightsaround the campfire, spinning tales of profits made and capitalgains taken? Well, if you want to have your gains and protect yourinvestment, too, you can find a measure of both credit safety andpotential appreciation in convertible bonds.

Convertible bonds are hybrid securities that sharecharacteristics of both stocks and bonds. As the name implies,these securities can be exchanged for a set number of shares of theunderlying common stock, and their price tracks that of the stockon the way up. But as fixed-income securities, they pay a fixedinterest rate like a regular bond. These interest payments cushionthe bond's prices when the stock declines, so convertiblesecurities rarely fall as far or as fast as their common stockcousins. For some investors, convertibles provide the best of bothworlds.

Investing With The Top Down

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

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

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

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

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

2. Yield advantage: Convertibles often have highercurrent yields than common stocks that pay dividends. To calculatethe yield advantage, subtract the current yield on thedividend-paying common shares from the higher convertibleyield.

3. Conversion price: This is the specified price pershare at which the convertible could be converted into commonshares. This information is found in the convertible's legaldescription, and the information should be available from yourfinancial advisor. If the underlying stock splits, conversionprices are usually adjusted.

4. Conversion ratio: This is the number of common sharesresulting from the division of the face amount of the convertibleby its conversion price.

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

6. Conversion premium: The percentage difference betweena convertible's actual market price and its conversion value iscalled 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 theyield advantage is created by a convertible's higher currentyield, relative to the current common stock yield. To calculate thebreak-even period, divide the conversion premium by the yieldadvantage.

At first glance, understanding these terms and their assortedpermutations may seem like an exercise in futility, sort of liketrying to replace the head gasket on your 1965 Mustang when youdon't even know how to change the oil. But if convertibles aresomething you'd like to add to your portfolio, you've gotto 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 beforeyou invest, make sure you know when the bond is callable. If it iscalled early, you may not get the chance for appreciation to repayyou for the premium you paid. And never buy a convertible unlessyou like the underlying stock. One way to find a good convertibleis to compare it with other issues in the industry.

Before embarking on a buying spree, John Carroll, first vicepresident and manager of convertible trading at PrudentialSecurities in New York City, suggests looking at more recentmodels. Carroll notes that convertibles issued several years agomay have already appreciated along with their stock. If theunderlying stock has risen 50 percent, the bond may have alreadyappreciated 40 percent. If the stock falls, the bond could besubject to the same kind of volatility. "Instead,"suggests Carroll, "buy convertibles selling near par in stocksyou otherwise like. If the stock goes up, you will participate [inthe profit] because you own the convertible, but if the stockdrops, you have less downside risk."

Check under the hood before buying, and kick the tires of theunderlying company, too. Because convertible bonds are subordinateddebentures, it's especially important that the issuer has astrong balance sheet. That way, you know you'll receive yourinterest 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 yourmechanic--I mean financial advisor--his or her opinion. Finally,consider buying bonds from larger issues so illiquidity won'tbecome a problem if you decide to sell or want to buy more in thesecondary market.

Other Models

So far we've looked at just convertible bonds, but there arelots of other types of convertible securities you might want toconsider before you buy. In addition to convertible bonds, somecompanies issue convertible preferred stock. Like convertiblebonds, convertible preferred stock is a hybrid security that hassome of the same characteristics of nonconvertible preferred stock.It, too, is usually callable, and its conversion valuecharacteristics are similar to those of convertible bonds. Themajor difference is that while convertible preferred stock tradesat a premium over both standard preferred and common stock, thepremium is smaller than that of a convertible bond over thecommon.

Taking A Spin

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

Some investors feel uncomfortable about putting all their eggsinto one investment vehicle. Fortunately, there are lots ofoptions. Convertibles come packaged in diversified, professionallymanaged portfolios, either by themselves or with other securities.This way, you can let someone else worry about conversion premiumsand call dates.

Before you invest, read the prospectus to be sure you understandhow the bonds will be managed and the manager's objectives.Open-end funds (which offer professional management anddiversification but trade on an exchange) are also available. Inboth cases, remember that past performance is no indication offuture returns. Whatever road you decide to take, happycruising!

Contact Sources

Jerald Melberg Gallery, 3900 Colony Rd., Charlotte, NC28211, (704) 365-3000.

Lorayne Fiorillo is first vice president of investments atPrudential Securities. She presents retirement planning andpersonal finance workshops worldwide. For more information, writeto her in care of Entrepreneur, 2392 Morse Ave., Irvine, CA92614.