Riding out the market in a convertible.

• Author: Calamos, John P.
• Position: Convertible securities - Personal Financial Planning

The 1994 stock market taught many investors the meaning of bond-market volatility. These days, "conservative bond investing" doesn't look like such a sure bet anymore. But don't let short-term developments discourage you from staying fully invested in the market. By using convertible securities, which combine the elements of bonds and stocks and exhibit certain investment characteristics of both, you can blend the advantages of fixed-income and equity instruments.

Convertible securities were first used more than 100 years ago to finance railroad construction, and the market volatility of the past 25 years has made them popular vehicles again. Many issuers, especially new companies with unseasoned securities, are adding the convertible option to preferred stocks or bonds to make them more attractive to buyers. Plus, seasoned and high-capitalization companies seeking worldwide securities distribution have begun to offer convertible bonds to foreign investors in the European bond market, a practice that will almost certainly grow as the securities markets continue to globalize.

How do convertible securities work? They can be either bonds or preferred stock, but it's easiest to understand them as bonds. A convertible bond is a regular corporate debenture with a fixed coupon and maturity date that can be converted into a fixed number of shares of common stock, at the holder's option.

THE BEST OF BOTH WORLDS

A convertible security has value both as a bond and as stock. Its bond or investment value is calculated by standard fixed-income analysis: maturity date, coupon, credit quality, company fundamentals, yield to maturity and call features. The investment value of a convertible bond remains stable over a wide range of stock prices and drops only as the stock price approaches zero, which means the company is nearing bankruptcy. In an uncertain stock market, the investment value of the convertible bond constitutes a floor value for the security. The investor can continue to hold the bond and collect the coupon interest, and he'll still be repaid at maturity.

A convertible bond is also valued in terms of its underlying equity, so it's important to remember that assessing the equity value of a convertible involves performing the same kind of credit analysis required for any stock. This means looking at the future prospects of the company, the risk measures of the common stock and how much equity participation the convertible bond represents.

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