By Raymond D. Mignone
With the recent market volatility retirees are looking for investments that combine some growth with good dividends. Convertible bonds are a good choice. For the past six months I have been using more convertible bond funds in client portfolios to reduce risk and position for growth and income.
As crazy as it seems, I increased my research into convertible bonds after seeing all of the retired veterans riding in convertibles with the tops down during this year’s Little Neck/Douglaston Memorial Day Parade.
Convertible bonds are debt that can be converted to equity at a specific time and price. They are used to lower debt costs to companies by making the debt holder a potential participant if the company’s stock price appreciates. You collect interest in the meantime and, if the company’s stock price appreciates sufficiently, you can realize capital appreciation. In essence, you are being paid to wait.
While this all sounds great, the choice of what to buy and sell is critical. Many of the issuers are young companies that need to provide the equity kicker to attract capital. Credit analysis is important. Also, the relationship among the bond’s price, conversion feature and yield requires the use of mathematical modeling. This is why it is best to use a mutual fund that is experienced in this area.
The real question is, why do this now? It is no secret that the equity market has fallen. As a result, many convertible bonds are “busted.” The equity conversion feature is of little value. That means the convertible is selling mostly on its bond value. The equity kicker can be had for little or nothing.
What you are paying to wait is lower than at most times in history. Of course, there could be higher interest rates with no corresponding increase in the price of the equity market, which is a scenario that represents additional risk for the holder of convertible bonds. Then, you could realize no gain from the equity portion of the bond and possibly suffer downside from higher interest rates.
If economic growth should materialize in a major way, and the equity market reawakens, the convertible feature will have more value. That means any higher interest rates that accompany an economic expansion would suppress the price of ordinary bonds, but not necessarily the prices of convertibles.
There is plenty of evidence to support the premise that the time is ripe for this asset class. The equity market has fallen. So have interest rates. Meanwhile, the economy is improving somewhat. That means a little more comfort for bondholders.
With convertible bonds we are bondholders. Should the situation improve for the equity side of things, it’s nice to know we could be stockholders, too. At a recent conference I attended one seminar on convertible bonds that suggested that they had 70 percent of the upside of stocks with 50 percent of the downside.
Selection of a good convertible mutual fund is key. I like to use the Calamos Convertible fund, and a good fee-based advisor can get you the fund without the sales load. Of course, it always is important to determine if this investment is appropriate for you. So with the summer heat I think it is a good time to think about convertibles! For more investment ideas, visit the News & Links section of my Web site: www.raymignone.com.
Raymond D. Mignone is a fee-only Certified Financial Planner & Registered Investment Advisor specializing in retirement planning and investment management; he can be reached in Little Neck at (718) 229-2514 or visit www.RayMignone.com
