Protecting and growing a portfolio with convertible bonds


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Convertible Bonds are an overlooked asset class that may help an investor increase portfolio income while protecting against the volatility of individual stocks. An important tool to help reduce risk and improve portfolio returns for retirement income portfolios.

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Protecting and growing a portfolio with convertible bonds

  1. 1. Protect and Grow Wealth with Convertible Bonds A Way to Improve Yields with Lower Risks in Any Investor’s Portfolio Prepared by: Steve Stanganelli, CFP®, CRPC® CERTIFIED FINANCIAL PLANNER (TM) Professional Clear View Wealth Advisors, LLC, a Registered Investment Adviser Amesbury, MA Wilmington, MA Office: 978-388-0020 or 617-398-7494 CELL: 978-621-8268 Fee-Only * Five-Star Rating * Board-Certified© Steve Stanganelli, CFP®, CRPC® and Clear View Wealth Advisors, LLC 2010
  2. 2. Convertible Bonds: An Overlooked Asset Class “If you stay out of stocks, you might miss the rally. If you buy stocks, you might get creamed in another slump. But convertible(s)…let you have it both ways.” From Forbes MagazineConvertible Bonds may be unfamiliar to most investors but they are a great tool for helping tominimize certain risks in almost any investment portfolio.Convertible Bonds can be an important part of any portfolio and can be structured toaccommodate any investor risk profile.For an investor who is seeking an income-producing portfolio, they can provide anenhancement to a traditional fixed-income portfolio. For a more growth-oriented portfolio, usingConvertible Bonds helps provide upside potential while receiving some income return. And inuncertain times of higher volatility or sideways markets, including this asset class helpsinvestors protect their core holdings.Whether an investor is concerned with stock market volatility or a market environment withhigher interest rates or inflation, Convertible Bonds provide an attractive alternative to traditionalstocks or bonds.Convertible Securities: A Hybrid InvestmentConvertible securities include both convertible bonds and convertible preferred stocks.Convertible Bonds are hybrid investment vehicles that offer the best of both worlds — incomenow like a bond and the potential to capture appreciation later like a stock.Convertible Bonds – A Bond with an OptionThe basic feature of any convertible security is its ability to be converted. Like a chameleonchanging color, the security can change from one type of investment to another. In the case of aConvertible Bond, an investor can exercise the option to exchange the security for apredetermined amount of shares in the common stock of the issuing company.The bond’s issuing documents outlines this predetermined amount as a conversion ratio. Forexample, if one is holding a bond with a conversion ratio of 10:1, then each bond can beexchanged for ten shares of common stock.The bond investor may be limited to when the exchange can be done. The issuing companyalso typically reserves the right to call the bond and force a conversion. Strengths  Original investment cannot go lower than the market value of the bond; the stock price does not matter until you exercise your option to convert into stock.  Convertibles can be purchased through tax-deferred retirement accounts.  Convertibles gain popularity in times of uncertainty. The best time to buy a convertible is typically when interest rates are high and stock prices are low. It is also advantageous when stock market direction is uncertain and© Steve Stanganelli, CFP®, CRPC® and Clear View Wealth Advisors, LLC 2010
  3. 3. other fixed income yields are relatively low. Weaknesses  The return on the bond or preferred stock is usually quite low.  "Forced conversion" can occur when the company makes you convert your bond into stock. It is important to track when these bonds are callable. Three Main Uses  Capital Appreciation  Safe Investment Compared to Other Options  Tax-Deferred Investment Shelters Income ReceivedThis chart illustrates the performance of a convertible bond as the stock price rises. Notice thatthe price of the bond begins to rise as the stock price approaches the conversion price. At thispoint your convertible performs similarly to a stock option. As the stock price moves up orbecomes extremely volatile, so does the bond. Source: Investopedia ( is important to remember that convertible bonds closely follow the underlying stocks price.The exception occurs when the share price goes down substantially. In this case, at the time ofthe bonds maturity, bond holders would receive no less than the par value, typically $1,000.Why Companies May Issue Convertible BondsConvertible Bonds have evolved. In the past, many were issued by smaller companies that didnot have other means of accessing capital. Over the past 15 years, Convertible Bonds havebecome more prevalent among larger brand name firms as well. Established companies haveturned to adding Convertible Bonds to their mix of financing options to lower the company’soverall cost of capital. The coupon on a Convertible Bond is typically lower than a straight bond.It also avoids diluting the Earnings Per Share (EPS) of common stock and may help in delayingloss of control of a company by issuance of a new block of common stock.© Steve Stanganelli, CFP®, CRPC® and Clear View Wealth Advisors, LLC 2010
  4. 4. Get Paid While You WaitConvertible Bonds offer investors a fixed yield like any other bond. This regular income offersbetter downside protection than simply holding the stock. They also have a feature that allowsthe bondholder to trade in the bond for a certain amount of stock on a predetermined date. Thisfeature makes Convertible Bonds advantageous during inflationary times when stock pricesmight be increasing and other bonds drop in value. During market corrections or bear markets,investors receive interest while waiting for the next recovery or bull market.Like any other bond, there is underlying credit risk of the issuer. The opportunity to convert alsomeans that the Convertible Bond may track the stock more closely and have higher volatilitythan straight bonds. Yet the hybrid nature of this investment provides corresponding benefits.Convertible Bond AdvantagesSolid Total Returns Compared to Fixed-Income OptionsAs an asset class, Convertible Bonds have been around for more than 150 years. SinceDecember 1973 through mid-2010, the Convertible Bond index has had total returns (interestplus appreciation) of 2736%, outpacing the government/corporate bond index by 943% and hi-yield (aka junk) bond index of 1585% (BofA/Merrill Lynch Convertible Research, 6/30/10).Solid Performance and Better Risk-Adjusted Returns Compared to Straight EquitiesHistorically, equities have offered a higher average annualized return compared to bonds. Yetthis higher potential comes with its own risks. To participate in the upside may require goingthrough uncertain periods subjecting a portfolio to wild fluctuations.For those with time on their side who are able to control their emotions, a portfolio may be ableto recover. But most individual investors are too emotional when it comes to investing and notprepared to lose. Emotion can sabotage their longer term investment plans. Research shows and common sense supports that what matters most in investing is how muchyou keep. Avoiding losses is easier than trying to make up lost ground.Convertibles offer downside protection which may provide ballast to a portfolio and avoid theneed to “play catch-up” by taking other undue risks with a portfolio that has suffered adrawdown caused by a market turn.This chart shows that investing in convertibles offers an advantage that can help balance out aportfolio especially in the recent up and down and sideways markets of this most recent decade.Clearly relying solely on any one asset class has its risks. In this case large company equitiesas represented by the familiar S&P 500 index have not offered a strong performance for therisks associated with them over the charted period.Through June 2010 S&P Total Return BOA/ML A0V0 Index15 Years 6.24% 7.34%10 Years -1.59% 2.30%(Source: Morningstar, Inc. and Wellesley Investment Advisors, Inc)© Steve Stanganelli, CFP®, CRPC® and Clear View Wealth Advisors, LLC 2010
  5. 5. Solid Returns During the “Lost Decade”During the last decade Convertible Bonds have proven resilient and a safe harbor compared tomost other equity categories. In the ten-year stretch ending July 2010 after three major stockbusts which saw the cumulative return on the S&P 500 come in at a negative 7.37%, the Bankof America/Merrill Lynch All Convertible index returned a total 32.64%. (Source: FinancialAdvisor magazine, November 2010, “Considering Convertibles,” Kahn, p. 119). Asset Classes Compared 1 Year 3 Year 5 Year 10 Year 22.64% -6.79% 17.70% 22.84% 23.38% -30.78% -6.73% -27.19% 14.43% -26.62% -3.90% -14.77% 21.50% -23.65% 1.93% 34.99% Thru 6/30/2010Source: Wellesley Investment Advisers and BofA Merrill Lynch Convertible Dept., 6/30/10Convertibles generally did better than their underlying stocks without the same level of exposureto market volatility or negative returns evident in long-only stock investing.Reasonable Holding PeriodsIn the past the opportunity to convert was limited or required a long holding period. Many nowoffer windows to convert to stock that are relatively short: 3 to 5 years, reducing the ConvertibleBond investor’s needed holding period to cash out and get his money back with interest or astock gain.Non-Correlated to the Stock Market Adding to DiversificationOne goal of diversification for investors is to reduce the impact of exposure to volatile markets.By spreading assets into different asset classes, the overall risk of the portfolio is reduced evenif the risks associated with the individual components may be high.The challenge in a global market where more and more asset classes and economies arebecoming ever more interdependent is finding an asset class that still is non-correlated,meaning an investment that won’t track the direction of another; one that zigs when otherinvestment asset classes zag.The following chart highlights the correlation between bonds, convertibles and the broader stockmarket represented by the S&P 500. Given the hybrid nature of Convertible Bonds, they showthat they are in between both stock and bond asset classes.© Steve Stanganelli, CFP®, CRPC® and Clear View Wealth Advisors, LLC 2010
  6. 6. S&P 500 TR Index Barclay’s Agg Bond BofA MLV0A0 Index Index S&P 500 TR Index 1 - - Barclay’s Agg Bond 0.01 1 - Index BofA MLV0A0 Index 0.67 .01 1 Source: Morningstar, Inc. Performance During Rising Interest Rate Environment During Fed tightening, Convertible Bonds have performed well. It is inevitable that interest rates will rise from their historically low rates with or without inflation. While the value of other government and high-quality corporate bonds will suffer when interest rates rise, Convertible Bonds will likely hold their value, continue to pay out interest and offer the potential of greater return when converted to stock compared to only holding long equities or other types of bonds. During two of the last 4 major Fed tightening cycles over the past 22 years, the returns on the Convertible Bonds index (Merrill Lynch V0A0) have shown clear advantages in two periods, competitive returns in a third and a loss in only one. Merrill Lynch Fed Policy Rate S&P 500 V0A0 Index InterestStart End Duration Start RateDate Date (months) Value End Value Increase Change (%) Change (%)03/29/88 02/24/89 11 6.50 9.75 3.25% 10.38% 11.20%02/04/94 02/01/95 12 3.00 6.00 3.00% 0.13% -8.46%06/30/99 05/16/00 11 4.75 6.50 1.75% 6.80% 26.47%06/30/04 06/29/06 24 1.00 5.25 4.25% 11.58% 8.67% © Steve Stanganelli, CFP®, CRPC® and Clear View Wealth Advisors, LLC 2010
  7. 7. Convertible Bond RisksNo investment is perfect and convertibles are no different.As with any bond there is the underlying credit risk of the issuer. In the event of a companydefault, there is the risk of losing one’s investment. A mitigating factor is that bondholders arefirst in line to receive proceeds from a company liquidation which is not an option forstockholders.As noted earlier there is the risk that the issuing company may force a conversion by calling thebond. This may occur at an inopportune time for an investor who was relying upon the incomestream generated by the bond. And the conversion to the underlying stock may not beappropriate for an individual investor’s risk profile which may require selling the stock and resultin an unexpected capital gain if the bond was not previously held in a tax-deferred account.The market float for Convertible Bonds is small compared to the value of equities and otherbonds. According to BIS (2004) reports, the total float of issues was under $400 billion. Whileideal for a niche investing strategy, the limited size of the market can make it susceptible tofreeze-ups in the market. This has happened in 1998 and 2005 and more dramatically in 2008.Convertible Bonds have been a favorite of hedge fund traders. By 2008, nearly 75% of allissuance was held by hedge funds. As liquidity and investor appetite for risk dried up in late2008, this lead to highly leveraged hedge funds in need of cash and liquidity to dump theirholdings at steep price declines and even losses resulting in a 35% fall in the Barclays CapitalUS Convertible Bond Index for 2008.© Steve Stanganelli, CFP®, CRPC® and Clear View Wealth Advisors, LLC 2010
  8. 8. An Illustration of a Convertible Bond Strategy in ActionFundamental analysis is key to implementing a Convertible Bond strategy.Because this is a niche area it lends itself to highly specialized investment managers who havethe research bench and resources to execute a strategy over entire business cycles. This ismore of a hands-on approach rather than an index approach.Some of the key elements to this approach are:  Focusing on “investment grade” stocks  Find convertibles with attractive provisions: short time period until call, put or maturity  Identifying companies with profits growing 10% + per year and strong corporate balance sheets with a ten year history of stability or strengthening  Analysis of the macroeconomic conditions and how they may impact the bond being issuedAn Example of What Can Happen When a Stock Appreciates: The Home Run *Home Depot (HD), 3.25% coupon convertible bond Convertible Bond StockNovember 25, 1996 $995.00 $51.88Purchased Home Depot Price Paid Per before split3.25% convertible bond Bond $17.29Due 10/1/01 – Convertible to43.402 shares HD after 3:2 and 2:1 splitsOctober 1, 1999 $3,011.95 $69.79Sold Home Depot convertible Per bond Including dividendsbond before Call Date of $0.23Callable 10/2/99GAIN (LOSS) 202.71%Interest Income 9.25% 303.64%In hindsight, a stockholder would have received a higher return compared to buying theconvertible and converting. While the convertible provides a cap on the upside, it offeredincome and downside protection.© Steve Stanganelli, CFP®, CRPC® and Clear View Wealth Advisors, LLC 2010
  9. 9. An Example of What Can Happen When a Stock Depreciates: The Strike Out *AOL Time Warner, 0% convertible bond Convertible Bond StockNovember 30, 2000 $501.25 $40.61Purchased AOL 0% Price Paid Per Per shareconvertible bond BondDue 12/6/2019 – Convertibleto 5.834 shares of AOL(Put on 12/6/2004 at $639.76per bond)March 28, 2002 $548.75 $23.65Sold AOL 0%convertible bond Per bond Per shareGAIN (LOSS) 9.47% - 47.16% * Source: Wellesley Investment AdvisersHolding the stock would have resulted in a significant loss in value. Hedging strategies couldhave been employed which would increase the cost of holding. Opting for the convertible bondprovided income and an opportunity to exercise the “put” by converting to the stock. Theconvertible provides a floor under the stock which reduces the investor’s risk.ConclusionsConvertible Bonds provide opportunities to build and protect wealth in uncertain times. Theyoffer investors compelling reasons to add them to their portfolio mix:1. Higher yield than most equities (presently > 3.5%)2. Potential to capture appreciation3. Enhanced diversification and lower potential risk resulting from low correlation with stocks and bonds4. Track record of preserving capital5. Unlike other bonds, Convertible Bonds have generally performed well during periods of increasing interest rates or inflationary periods.© Steve Stanganelli, CFP®, CRPC® and Clear View Wealth Advisors, LLC 2010