Despite the wide range of investments available, conservative investors often have difficulty finding securities that match their objectives.
Convertible bonds and convertible preferred stocks offer an attractive alternative to more traditional types of investments. They offer a unique combination of traits that enable investors to profit from any improvement in the stock market while earning a higher current income, with greatly reduced risk.
Although convertibles have become a popular investment for mutual funds and pension managers, many small investors are unfamiliar with the advantages offered by these securities.
Like other bonds or preferred stocks, convertibles pay a fixed amount of interest or dividends every year, typically well above the yield of the common stock. The average yield offered by convertibles usually is more than double that of stocks in the Standard & Poor's 500 index. This yield also compares favorably with the return offered by money-market funds.
What makes convertibles unique is that in addition to providing a high current income, they also can be exchanged for a predetermined number of common shares at any time. This number of shares, which is referred to as the security's conversion ratio, is set at the time the convertible initially is issued and remains the same over the life of the convertible unless there is a split of the underlying common stock, in which case the ratio is adjusted upward.
This right to receive a set number of common shares obviously becomes more valuable as the common stock rises, and the convertibles' value therefore will increase as the stock moves up.
As a result, convertibles provide more potential for capital gains than can be found in other fixed-income securities. At the same ** time, the higher, more secure yield offered by convertibles provides an attractive current income if the stock remains flat, and also helps limit a convertible's decline if the underlying common stock falls.
The importance of this risk-reduction feature was evident in the sharp stock market plunge in October 1987. From Oct. 5 to Nov. 2, the Value Line Composite Average, which is a broad-based index measuring the performance of the convertible market, was down just 15.2 points. Over the same period, the Dow Jones industrial average lost more than 600 points.
This unique combination of appreciation potential, high current income and reduced risk makes convertibles highly attractive as alternatives to both common stocks and bonds, especially for more conservative investors who expect stock prices to rise over the long term but who are unwilling to purchase common stocks due to their low yields and relative risk.
Since a convertible's value will move in the same direction as the underlying common stock to a degree, it is important to purchase convertibles only on stocks that you expect to rise, although the higher yield and lower risk of convertibles give you more leeway in the event the stock does not perform as expected.
Determining the attractiveness of a convertible requires thorough analysis of a wide range of factors in the stock and bond markets, as well as the convertible's specific attributes.