Why Convertible Bonds Should be Part of Your Asset Allocation

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
March 20, 2012

IN THIS ISSUE:

1. The Best Asset Class You’ve Never Heard About

2. Greg Miller: An Asset Class to Consider

3. Convertibles – NOT for Hot Money

4. Frequent Trading Hampers Principal Protection

5. The “Secret Sauce:” Convertible Bonds with Put Options

Introduction

It is certainly no secret that I highly respect and value Greg Miller and his staff at Wellesley Investment Advisors. Of all of the professional money managers we recommend at my company, I have my largest personal account with Wellesley, and even most of my kids’ trust money as well.

Yet, there are many of my clients and readers who have not yet requested information on this successful investment strategy. In talking with some of them who had not requested information on Wellesley, I found that the number one reason was the fact that they did not understand how convertible bonds work. I hope to change that today!

It’s not because convertible bonds are secretive and mysterious like some hedge funds. In fact, they are very straightforward financial instruments available on public exchanges and with full transparency. Yet, the characteristics of convertible bonds make them one of the more unique investments available, and certainly able to provide additional diversification in virtually any portfolio.

This week, I’m going to let you hear directly from Greg Miller about convertible bonds. Not only will Greg tell you how they work, but also why they can be an important diversification technique in your portfolio – even now when other types of bonds are falling out of favor.

I hope you will read what follows because I believe that many of you will want to have convertible bonds in your portfolio before long. The interest rate increases we’ve seen over the last couple of weeks may be a sign that the long bull market in traditional bonds is rolling over to the downside. Convertible bonds offer opportunity even during periods of rising interest rates!

Without further delay, let’s hear what Greg has to say.

An Asset Class to Consider: Advantages of Investing in Convertible Bonds
By Greg Miller, CPA

QUOTE:

The cover of the January 30, 2012 Barron’s boldly states:

DON’T LOSE MY MONEY!!!
Despite the recent rally, investors still worry about preserving capital. More than ever,
investors want advisors and money managers to preserve their capital.

Who can blame investors for wanting principal protection? During the last twelve years investors have witnessed: the blow up of the dot.com and tech bubbles; a global debt implosion resulting in a severe crash and bear market; the demise of major financial institutions including Lehman Brothers, Bear Stearns, and MF Global; the demise, or near demise, of former blue-chip companies like Eastman Kodak, General Motors, Ford, Citigroup, Enron, WorldCom, and AIG; the multibillion dollar investment scam of Bernie Madoff; high oil prices; falling house prices; a European solvency crisis; and one of the worst recessions in American history. Investors brave enough to remain in the markets have very recently ridden out extreme volatility, two steep bear markets, and one frightening free-fall “flash crash.”

Barron’s recently stated that investors want advisors to make sure they don’t lose their clients’ money:

“Investors may be resigned to diminished returns, what with bond yields plumbing historic depths and banks paying almost no interest, but their biggest priority remains to avoid, at all cost, a repeat of the 2008's disastrous losses.”

To rise to that challenge, advisors should consider the asset class of convertible bonds. Convertibles can offer unique features: unlimited upside potential, and the downside protection so important to investors right now. A convertible’s fixed income value, the bond portion of a convertible, can act as a “floor,” offering downside protection and limiting downside exposure to declines in the underlying stock. Since convertibles can be exchanged for the underlying stock, a convertible can serve as an equity surrogate, a fixed-income debt instrument, or a combination of both. The relationships among current price, conversion value and investment value determine a specific convertible’s performance and price movements.

The conversion value of a convertible bond is usually a straightforward calculation. It is the number of common shares for which the bond may be exchanged, multiplied by the price of the common stock.

Calculating investment value, however, is not as simple. “Investment value” is the value at which a straight, non-convertible debt instrument would trade if the instrument did not have an equity call option. In general, most of the time, buyers of convertible bonds accept lower yields than those associated with straight debt instruments of the same company with the same maturity dates. This is in exchange for the warrant or conversion privilege, which offers a possible play on the underlying common stock. Often, companies issue convertible bonds since they can acquire capital at a rate that is 1% to 2% below the interest or dividend rate that would have to be paid on a straight bond or stock. Investment value is more difficult to calculate since it depends on a number of factors including maturity, call risk, and the issue’s investment grade or quality of the bond.

Advantages of a Convertible Bond Investing Program

There are many advantages to a program of investing in properly selected convertible bonds. Properly chosen and managed, convertible bonds can offer the safety and principal protection of a bond, coupled with a call option on the underlying stock. In a downward-trending stock market, convertibles generally will tend to hold their value as bonds, and in rising markets, convertibles can derive a majority of their value from the appreciation of the underlying common stock.

Unlike dividend-paying stocks, interest on a convertible bond cannot be lowered at the whim of the board of directors. Properly selected and managed, convertible bonds can provide investors with a laddered guarantee of return of principal, something dividend stock investors only dream of. Many high dividend paying blue chip stocks have never, and may never, return an investor’s original principal, even if the company continues to survive. A convertible bond portfolio can be structured to offer a complete return of principal, barring issuer defaults. Convertibles’ higher yields may also be a draw for many investors. The average convertible bond currently has a current yield of 4.01%, whereas the average yield from the stocks underlying the convertible bonds only pays dividends of 1.11%.¹

Barron’s recently wrote:

Coming so soon after a lost decade of returns, investors can be forgiven for fretting about their investments. Hobbled by the bursting of the tech and debt bubbles, the S&P 500 ended the 2000s with a total return of -0.96%, the worst decade since the 1930s’ 0.33% haul… Investors, too, should start rethinking what constitutes a safe, productive portfolio.

Value Line states:

Historical studies show that on a total return basis, convertibles generally offer competitive returns to equities (though slightly lower depending on the time frame) with much less risk. As a result, on a risk-adjusted basis, convertibles offer one of the highest reward/risk ratios of all investment instruments^.²

_____________________________
¹ The Value Line® Convertible Survey, February 13, 2012
² The Value Line® Convertible Survey, January 23, 2012

UBS, in a white paper entitled The Benefit of Convertible Bonds, sums up why every investor's portfolio should own convertible bonds:

This, in our view, is the basis for the attractive risk/return relationship convertible bonds have exhibited in the past, and why we expect … this attractiveness to continue into the future. Therefore, we think allocating to convertible bonds within a diversified portfolio is a pragmatic and valuable investment decision that allows the investor not only to gain convexity and diversification benefits, but also exposure to the attractive risk/return properties of convertible bonds^.³

Investors have suffered a veritable financial Armageddon over the past ten to twelve years. As they work to rebuild both wealth and trust, advisors should heed client mandates for increased attention to protection of principal. The asset class of convertible bonds presents advisors with new and interesting ways to accomplish exactly that.

__________________________
³UBS Global Asset Management, The Benefits of Convertible Bonds, White Paper Series ©2007

Convertibles – Not For Hot Money

Like many investment professionals, we have always believed that accomplishing positive, repeatable and sustainable returns over time requires a long-term investment horizon. We leave the short term strategies to others, while we focus on five or more years as an appropriate and meaningful timeframe.

Investing in convertible bonds while also deploying an absolute return investment strategy makes this especially true. Convertible bond investors need to have a reasonably long-term investment focus for two important reasons: (1) the high cost of trading, and (2) the inability to fulfill an absolute return goal, if not investing for the long-term.

Investor Time Horizon Key to Success in Convertible Bond Investing

A sacred principle in investing involves consideration of risk tolerance and time horizon. Both are important, but time horizon becomes paramount in the bond world, where frequent traders can get killed by spreads.

All securities trade with a “bid” price, an “ask” price and a “bid/ask” spread. In comparison to stocks, most bonds have much broader bid/ask spreads. Bonds are generally less liquid than stocks, and often do not trade electronically or on listed exchanges. Larger spreads on individual bonds make them more costly to trade with frequency, or even to periodically rebalance.

Convertible bonds, especially many of the more attractive, smaller issues, typically have significant bid/ask spreads. Trading convertible bonds in small lots, or very frequently is not recommended for this reason.

In recent years, some of the most compelling convertible bonds have been part of smaller debt issues of under $300 million. These bonds trade at the greatest spreads, and frequent trading or trading in small lots is inadvisable. Trades of ultra-small lots – say, under $10,000 – can produce very poor results, as spreads in this case can be as high as 2%.

However, for longer term investors with time horizons of five years or longer, the bid/ask spread may only represent 50 basis points or less: a worthwhile sacrifice for the possibility of accomplishing superior returns. The possibility exists: the Bank of America/Merrill Lynch Convertible Bond Index (V0A0) has returned almost 7% over the last 15 years, outperforming most other markets. As a convertible portfolio matures, it will tend to hold bonds that have significant appreciation due to a rise in the underlying common stock. In these cases, liquidating and giving up a small piece of a larger profit can be a small price to pay for good results.

Convertible bond investors, like investors in many other types of investments, should have an investment perspective of five years or longer to accomplish the best possible results.

Frequent Trading of Converts Hampers Principal Protection

The primary goals of an absolute return strategy deploying convertible bonds are:

To obtain positive returns during both bull and bear markets, and
To outperform both equities and fixed income over complete market cycles

This strategy involves two important steps:

Purchase only convertible bonds with No Loss To Worst (“NLTW”), and
Purchase only convertibles with short-term maturities or that have puts of less than 7 years

Purchasing convertibles with NLTW means that if a convertible bond pays 3% interest and the bond has a maturity of five years, the buyer would be willing to pay up to 115 or $1,150 for the convertible bond, but not more.

Here’s why:

At a price of $1,150 per bond, the investor’s principal is 100% protected, if the bond is held to maturity and assuming no default. The interest on the bond at 3% or $30 per year would total $150 over five years. The interest payments, plus return of principal would completely repay the original investment, providing “absolute” return of, in this case, $0 (no return, but no loss), even if the underlying stock price did not increase, or even if it fell. The objective, of course, is not to simply break even. However, breaking even on a bad stock selection is better than losing!

Inherent in this strategy, however, is the concept of time. If the underlying stock does not rise enough to create a corresponding rise in the bond value, or if in fact the stock price falls, the best thing for the investor to do may be to wait and to continue to collect the interest payments. However, the investor who constantly trades can severely handicap the principal protection component and ultimately, decrease his chances of accomplishing true absolute return.

Most investors and financial professionals have had the disappointing experience of selling a security, only to watch it take off shortly thereafter. If only we had known! With convertibles, we do know, and it usually pays to be patient. Failing to hold convertible bonds until the next liquidity event can result in permanent losses, and worse, squanders the opportunity for principal protection of the overall portfolio.

Investors with frequent liquidity needs, frequent traders, or those who do not have the appropriate time horizon still have options. Although we still caution against investing funds that will be needed in the shorter term, a better solution can be to invest in a convertible bond mutual fund. Open-end convertible bond mutual funds usually have smaller bid/ask spreads than separately managed accounts based on their economies of scale.

Convertible Bonds with Put Options

In 1995, Merrill Lynch and Waste Management issued a zero coupon convertible bond, with a put option embedded in the prospectus. That is the first instance of convertible bonds having a put option that we know of, and since then, more and more convertible bonds have put options. A put option on a convertible bond gives investors the opportunity, at a time prior to maturity of the bond, to force the issuer to repurchase the debt at a predetermined price. The put option enables investors to sell the bond back to the company on specific dates for specific prices, usually at par or $1,000.

Years ago, put options mainly were offered only with convertibles that were issued as zero coupon bonds, or at a deep discount to par. However, the picture has radically changed and now, most convertibles issued with maturities of over seven years have put options. Most convertibles that come to market today with maturities of over 20 years or more also have put options, giving investors in convertible bonds the ability to effectively shorten the life of the bond.

There are two types of puts: “hard” and “soft.” With hard puts, the issuing company pays the bondholder cash upon settlement, usually par value. With soft puts, the issuing company can settle the put in cash, stock, or notes, and/or a combination of these, at the option of the issuing company. Hard puts are usually preferable because even though the stock, notes and cash from soft puts must equal the stated value of the put, there can be no guarantee the stated value will actually be realized when the securities are sold at a later date.

Put options are a very attractive feature for investors because they can, at the bondholder’s option, shorten the maturity date, with different redemption values. The yield to put calculation (“YTP”) can result in a number vastly different from the issue’s yield to maturity (“YTM”). Many times the YTP is greater than the bond’s YTM, making it preferable to exercise a put on the specified date, rather than hold the bond to maturity. Puts also give the convertible bond holder the right to put back “busted” convertibles where the probability of receiving more than yield to the next put or maturity may be unlikely because the underlying stock price has dropped significantly, with little perceived chance of rebound.

Another benefit of a put in convertible bond investing is that investors who buy bonds with positive YTW can reasonably be assured of a positive return, providing the company remains financially sound. The lesser of the YTP and the YTM are referred to as yield to worst (“YTW”) in the convertible world.

The value of a convertible bond is derived from the levels of its conversion and investment values. Theoretically, a convertible bond should not trade below its investment value because fixed income investors should support its price at this value. Convertibles with put features have two investment values: one based on the put price and the other based on maturity. The put price creates a second investment value “floor” below which the bond should not trade, offering convertible bondholders additional safety.

Convertible investors should realize that if a bond is trading on its YTP and the put date passes, the bond price will drop to a price supported by either its YTM or, the next put (if another put exists). If a bond’s YTP is higher than the current yield or YTM, and it is not supported by the issue’s conversion value, as the put date draws near, it may be wiser to sell or put the bond back instead of holding the bond, as the price of the bond can drop significantly after the put date passes.

Convertibles with puts can provide holders with a “floor” value that reduces downside risk. Put options are a very unique and appealing feature that help anchor principal and allow investors a broader slate of options. Such choices can become complex, however, and most individual investors can benefit from the expertise of an investment professional that specializes in convertible bond management. END QUOTE

Conclusions

At this point, I usually try to summarize what has come before but I think it’s unnecessary in this case. In the above article, you have learned about convertible bonds from one of the top experts in the US on these investments, so much so that the Morningstar organization named Wellesley Investment Advisors as the top performing convertible bond manager in America for the last 15 years.*

It seems that everyone today is seeking top-performing money managers that seek to provide absolute returns with controlled risk. Here’s the good news – you just found one!

To learn more about the Wellesley organization and its Limited Risk Investing program, contact Halbert Wealth Management in any of the following ways:

Give us a call at 800-348-3601 and ask to speak to one of our Investment Consultants;
Send an e-mail requesting information to info@halbertwealth.com;
Visit our website at www.halbertwealth.com and click on the “Contact Us” link at the top of the page; or
Click on the following link to access our Wellesley online request form.

Best personal regards,

Gary D. Halbert

Read Gary's latest blog post: Interest Rates Jump to Five Month High

NOTE: There is a risk of loss with this investment. Please read important disclosures before making a decision to invest.

*Source: Morningstar Direct. Morningstar, Inc. All rights reserved. Morningstar is an independent provider of financial information; performance rankings are based on total return without sales charge with similar objectives and determined by Morningstar. Period of performance: all ranked convertible SMA managers from 12/31/96 – 12/31/11. Past performance or ranking is not indicative of future results.