A Bond That's Also A Stock
- Tuesday, June 06, 2000
Reprinted with permission from World Finance Net IPO Newsletter, written by Alexander Frauenfeld
Are you one of the unfortunate investors haunted by today's turbulent markets, losing more and more sleep the choppier the markets get? Here is one potential antidote: Convertible Bonds.
Convertibles are corporate bonds that the buyer may exchange, at some point in the future, for a fixed number of shares of the issuing companys common stock.
The good news is that because they are bonds, with fixed interest payments and maturity dates, convertible bonds are much less volatile than common stock. And in the event the company does very well and its stock rises in value, you can convert your bonds into stock to take advantage. On the negative side, convertible bonds pay lower interest rates than traditional bonds, and generally trade in line with the common stock of the company.
The convertible markets all over the world are growing, with the telecom, media, and technology sectors starting to account for a growing percentage of them. That is likely to increase further, as the New Economy expands and companies in these sectors seek more capital. Once the preserve of institutions and wealthy individuals, convertibles are also expected to develop a broader investor base.
Here is how it works. Say a company issues a convertible equivalent to $1,000, with a certain annual coupon (interest payment to the buyer). Each bond can be exchanged for a predetermined amount of common stock over its life. If an investor has not swapped the bond for shares at maturity, the $1,000 face value is repaid.
When first issued, convertibles are often valued somewhere between equities and bonds. But rising stock prices can push the convertible's price up so high that the bond begins to behave like the company's stock. With the appreciation in the stock market in the last few years, many convertibles fall into this category. If the stock prices tank, however, convertibles begin to behave like straight bonds as they approach maturity. The bond price actually will act as a price floor for the convertible, even if the stock falls totally out of favor.
Why would a company issue such securities to begin with? Conversion features are usually added to make a corporations bonds more attractive. Additionally, convertibles can be sold with a lower coupon rate due to the added conversion feature. A company can eliminate a fixed interest charge as conversion takes place, thus reducing debt without having to pay anything back. Because conversion usually occurs over extended periods of time, if at all, the stock price is not as strongly effected as may occur with a secondary offering of stock. A convertible, in the short run, also avoids immediate dilution of primary earnings per share.
As is true for anything, there are also some downsides for the company. For example, when bonds are converted, shareholders equity is diluted. Because common stockholders have a voice in the companys management, a substantial conversion could cause a shift in the control of the company. Additionally, reducing corporate debt through conversion results in a loss of leverage. Finally, the resulting decrease in deductible interest costs raises the corporations taxable income.
The advantages for individual investors are significant. Convertible Bonds often provide as much as two-thirds of the gains you would get from the underlying equity, at around half the risk. In other words, they tend to be a safe haven in a falling market, when an investor does not completely want to abandon the equity markets.
Additionally, as a debt security, a convertible debenture pays interest at a fixed rate and is redeemable for its face value at maturity, provided the debenture is not converted already. In the event that the corporation experiences financial difficulties, convertible bondholders have priority over common shareholders in the event of a corporate liquidation. In theory, a convertible debentures market price tends to be more stable during market declines than the underlying common stocks price. Finally, the conversion of a senior security into common stock is not considered a purchase and a sale for tax purposes.
There are other things to watch for as well. Pay attention to the issuer's credit rating. Also check whether the issuer is allowed to call (force you to allow it to redeem) the bond. Convertibles also can have different twists. For example, some convertible bonds can actually be redeemed at a different price than where they offered. Higher volatility than traditional bond investing has to be expected, since the Convertible trades more in line with the common stock.
One of the best ways to get into convertibles is through Convertible Bond Funds. You sacrifice some upside potential when you invest in convertibles. But, with the hair-raising volatility of technology stocks these days, that could be a price worth paying.
For this week's IPO analysis and additional investment research, visit World Finance Net.
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