"HOW TO BUY CONVERTIBLE BONDS"
WHAT IS A CONVERTIBLE BOND ?
A convertible bond, is a bond of a corporation that can be exchanged for another security, usually the common stock of the same corporation. Generally, no payment is required to effect "conversion" other than the surrender of the bond. The convertible bond will always sell above its "conversion value", there are usually no reason to "convert" the bond. As an average, the convertible bond will trade approximately at a 20% to 25% premium above its "conversion value", (conversion ratio X price of common share). The conversion privilege normally lasts for the life of the bond.
WHY ARE CONVERTIBLE BONDS ISSUED ?
Convertible bonds are usually issued by corporations when other means of raising money would be more expensive. The conversion feature is a "sweetener" to pursuade investors to accept a rate of interest on a bond that is below prevailing levels. They do so because if the price of the stock rises in value, the value of the convertible bond will rise with it.
WHERE CAN I BUY CONVERTIBLE BONDS:
Convertible bonds can generally be bought and sold anywhere where stocks and bonds are traded. Many convertible bonds are listed on different markets, others are traded O.T.C. (over-the-counter).
WHAT IS THE MINIMUM AMOUNT THAT CAN BE BOUGHT?
There are generally no minimum amount to buy.
HOW TO READ THE CONVERTIBLE BOND PRICE.
In financial publications, corporate convertible bonds listed on the exchanges are distinguished from nonconvertible bonds by the designation of "cv" in the current yield column. Convertible bonds are usually issued at "par" ($1000), they are redeemed at maturity, also at "par" ($1000). They pay interest twice a year.
In the newspapers, the price of convertible bonds are quoted in "hundredís". Ie; When the price of the convertible bond is trading @ $1000, it will be quoted in the newspapers as trading @ $100 ($1000 / 10).
The conversion ratio (the number of shares that the bond is convertible into) is usually quoted as the conversion ratio divided by 10, Ie: If the conversion ratio is quoted @ 10, the bond is then convertible into 100 common shares, (10 X 10).
NEW INVESTMENT MEDIUM.
Before committing any investment to a "new investment medium", one has to do a research to find out at what point of the investment cycle that new medium is situated.
If you were to invest in the common shares of a Gold mining company,
first, you would like to know at what point of the cycle is the market (Dow Jones),
secondly, you would want to find out at what point of the cycle is the Ďgroupí into which the company you want to buy is located, in this instance, the ( Gold group),
thirdly, at what point of the cycle is the gold company into which you want to invest.
This should tell you if the "market" is going up, if the "group" is going up and finally if the "company" is going up. If those three indicators are going up, You can feel more secure in your investment. (Short term at least).
Investing in Convertible bonds is no different, you have to do your homework also.
ELEVEN YEAR RESEARCH:
I have just finished a research where I went back eleven (11) years to the first week of 1990. I have used two main selection criterias, 1) Price of convertible bonds below $1000, 2) Conversion premium of less than 50%.
For the eleven (11) years, the AVERAGE:
1 ) Number of companies fitting the selection criteria per week was 65,
2 ) The average coupon rate was 6.13%,
3 ) The average maturity date was 2006,
4 ) The average bond price was $904.68
5 ) The average current yield was 6.84%.
WEEK OF APRIL 17, 2000 RESEARCH:
On the week of April 17, 2000, the AVERAGE:
6 ) Number of companies fitting the selection criteria per week was 19,
7 ) The average coupon rate was 5.41%,
8 ) The average maturity date was 2005,
9 ) The average bond price was $871.32
10) The current yield was 6.26%.
A ) The number of companies meeting the selection criteria is much lower now than in 1990. The main reason is that the price of the bond is attached to the price of the underlying common share through the conversion ratio. Eventually, as the price of the underlying common share increases, it pushes the price of the convertible bond above and beyond the $1000 selection criteria. Other companies that had issued convertible bonds with coupons of 8%, 9% 10%, have recalled their convertible bonds to do refinancing at lower cost. (19 vs.65), #6 and #1.
B ) Convertible bonds, are usually introduced with a coupon rate that is around the prevalent interest rate. Since interest rates have declined, the coupon rate has declined also. (5.41% vs. 6.13%), #7 and #2.
C ) Some eleven years ago, convertible bonds were issued for an average of twenty (20) years. Presently, convertible bonds are issued for five (5) to ten (10) years. The combination of new "shorter term bonds" and long term bonds having been recalled, has reduced the maturity date by one (1) year. (2005 vs. 2006), #8 and #3.
D ) Although the indices (Dow Jones, Nasdaq) have been increasing, as everybody knows, it is mostly High Tech. and Internet companies that have been leading the market. For the last two (2) years, 1998, 1999, most of the rest of the market has been in a bear market, depressing the price of common shares and convertible bonds alike. The average price of bonds has decreased. ($871.32 vs $904.68), #9 and #4.
E ) The convertible bond yield usually follows the direction of interest rate, since interest rate have been decreasing in the last few years, so has the convertible bond yields. (6.26% vs 6.84%), #10 and #5.
From the results of the research of April 17, 2000, we could conclude that Convertible bonds could be bought at "prices" between $871.32 and $1000 as long as the "current yield" is around 6.26%.
Since the convertible bond is issued @ $1000 and redeemed @ $1000, the "safe" way to invest is to never pay more than $1000 per bond. Remember, if the company calls back their convertible bonds, they usually call them back @ $1000.
Convertible bond investments should be selected using a mixture of those three selection criteria.
This mixture should depend on your personal investment goals.
1) Current yield,
2) Yield to maturity,
3) Conversion premium.
"THE BEST OF BOTH WORLDS".
Convertible bonds, are part Debt and part Equity,
When the price of the underlying common shares decreases:
The convertible bond trades closer to itís Debt component.
When the price of the underlying common shares increases:
The convertible bond trades closer to itís Equity component.