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Convertible Bonds: Much Of The Upside With Less Downside

Since the beginning of the year, Income Insights has featured a range of investment vehicles including dividend-paying stocks, master limited partnerships, preferred stocks, bonds, floating-rate funds, equity income funds and utilities. Today, The Turnaround Letter Editor George Putnam introduces one more option for income investors: convertible bonds. “Convertible bonds are...

“Convertible bonds are an attractive vehicle for investors who want equity-like returns but cannot bear the volatility of stocks. A convertible may also provide more current income than the underlying stock.

“A convertible bond is a bond that can be exchanged for stock at a certain price ratio. As a bond or a debt obligation of the company, the convertible pays you interest periodically and then pays you back your principal at maturity even if the stock declines in price. It also gets paid off ahead of the stock if the company files for bankruptcy. These bond-like characteristics usually keep the convertible from falling too far if the company has poor results.

“The trouble with straight bonds is that your return is limited to the principal plus interest. And prior to maturity, straight bonds can fall in price when interest rates rise. However, a convertible gives you considerably more gain potential. If things go well for the company and the stock rises, you can exchange your convertible for stock and participate in most of the equity gains. Moreover, this equity gain potential often reduces the negative effect of a rise in interest rates.

“Of course, there is no totally free lunch. From a bond investor’s point of view, convertibles usually pay lower rates of interest than straight bonds, and they are often junior in right of payment (meaning that they are less likely to get paid off if the company files for bankruptcy). From the stock investor’s point of view, the exchange rate for the stock is usually set at a high enough level that you give up some of the upside if the stock rises. But for those willing to make these compromises to reduce volatility, convertibles can be very appealing.

“Convertibles can be particularly attractive in turnaround situations, which often have great gain potential but also significant risk of loss if the turnaround doesn’t pan out. If you can find a convertible where the stock price is not too far below the conversion price, you can capture most of the gains if things go well, and your risk of loss is significantly reduced if things go badly. The companies discussed below appear to be in the process of turning around to some degree, and they all have bonds that are convertible into stock at attractive prices.

“AMR (NYSE: AMR) and United Continental (Nasdaq: UAL), two of the largest U.S. airlines, have been showing signs of strong recovery recently as the economy strengthens and business travel increases. We expect the good results to continue, but airlines can be notoriously volatile because they are vulnerable to a host of factors such as economic conditions, oil prices and even terrorist activity.

“Ciena (nasdaq: CIEN) is one of the premier telecom equipment makers, a group that has seemed to be on the verge of a rebound ever since it crashed in 2000. Telecom equipment sales may finally be poised to pick up, but the Ciena convertible bond may be a better way to play this sector in case the recovery is delayed yet again.

“Evergreen Solar (Nasdaq: ESLR) was a darling of ‘green’ investors not so long ago, with its stock topping 18 in early 2008. The company has been hurt by foreign competition recently, but it has the potential to come back as solar energy comes into more wide-spread use. These bonds have a very high current yield, but they might not recover much if results don’t improve and the company is forced to file for bankruptcy. ...

“MGIC Investment (NYSE: MTG) is the leading private provider of mortgage insurance. Its results are improving as the housing industry stabilizes. Moreover, the federal government has indicated that it wants to turn more of the mortgage insurance business over to the private sector. The convertible bond gives you some protection if housing losses pick up again. ...

“Morgan Stanley (NYSE: MS), as we mentioned last month, is one of the two remaining large investment banks in the U.S. (with Goldman Sachs). It is well positioned to move higher if the financial recovery continues, but the convertible gives you downside protection if either the sector or the company falters.”

George Putnam, III, The Turnaround Letter, 11/10

A graduate of both Harvard Law School and Harvard Business School, George Putnam III first became involved with distressed securities as a lawyer in the late 1970s. Seeing the inefficient niche that bankruptcies and turnarounds presented when researched, he founded New Generation Research, Inc. and began publishing “The Turnaround Letter” in 1986. Since then, he has frequently been quoted in Barron’s, The Wall Street Journal, New York Times, USA Today and other financial publications. In 1990, he was named investment advisor of the year by USA Today. In addition to his responsibilities at New Generation Research, Mr. Putnam also serves as a trustee for The Putnam Companies, a mutual fund group with over $100 billion in assets.