Investing in convertible securities
Tap into a security’s upside potential with a component of downside protection
For many investors, convertible securities remain an unknown or they get overlooked when it comes to asset allocation. However, these hybrid investment vehicles offer a lot of potential benefits that appeal to both fixed income and equity investors. For example, the structure of convertible stocks and bonds can help preserve capital, reduce volatility with the bond component and capture upside potential from an equity conversion.
They’re typically issued as bonds or preferred stock that can later be converted to a specific number of common stock shares. That means you can benefit from both the income and downside protection inherent in the fixed income portion and profit from any potential price appreciation of the underlying common stock. In short, they offer you a defensive way to invest in equities.
Potential Investor Advantages
- A company’s convertibles are typically less volatile than its common stock, providing upside participation should the stock price increase and downside protection should the stock price decrease.
- While past performance is no guarantee of future results, studies show that convertible securities historically produce near-equity returns over the long term, while assuming less risk, thus making them an effective product for portfolio diversification. (Source: Bloomberg. Ten-year returns ended December 31, 2011)
- Most convertibles feature what’s called yield advantage. That means they’ll pay you a fixed income stream that is typically greater than the dividend yield a common stock shareholder would receive.
- Because convertibles are higher ranking than common shares within the company’s capital structure, you’ll have unsecured claims on its assets and receive a higher recovery value in a bankruptcy or liquidation.
To find out if convertible debt securities are right for your overall financial strategy and to discuss any risks involved, please contact your Raymond James financial advisor.
Addressing Risk
Of course, all investments involve a level of risk. Convertible securities are no exception. You will want to discuss these with your financial advisor before investing in convertibles. Market risk is the prospect that the price of the convertible will decline if market conditions change (e.g., interest rates, credit quality, liquidity or the value of the underlying common stock). Reinvestment risk is the possibility that coupon payments will be reinvested at a lower rate. Call risk is the possibility the issuer will call the convertible prior to maturity and/or at a lower price than the purchase price.
Liquidity risk reflects the possibility that inadequate demand might hinder selling the convertible in a timely fashion at an acceptable price. Dividend risk is the prospect that the underlying company increases its common stock dividend but the convertible debt’s yield doesn’t rise to match it. This may reduce or even negate the yield advantage over the common stock. Most convertibles are issued with provisions that require the company to adjust the conversion ratio to compensate convertible holders should the dividend increase.
Takeover risk is the possibility that another company will acquire the issuer, which may change the conversion terms and options. This can also result in a change in the issuer’s financial makeup. Default risk stems from the likelihood of the issuer becoming insolvent and unable to repay bondholders their principal at maturity and/or unable to make periodic coupon payments. Currency risk is the risk that changes in exchange rates will affect the convertible security.
Taxation risk involves a wide range of income tax implications regarding coupon, principal accretion and conversion that can vary by structure and issue. In some cases, investors may be taxed for a larger portion of income than they actually receive, resulting in reduced cash flow.
Diversification and asset allocation do not guarantee a profit nor protect against loss.
