Searching for Income - Convertible Bonds

In response to the economic crisis that began in 2007, the Federal Reserve has purposefully driven interest rates down in order to stimulate our economy. This artificially low interest rate environment has wreaked havoc on retirees who are dependant on interest from their investments to pay their bills and run their retirement lifestyle. As a result, retirees are constantly scanning the investment horizon in search for higher returns. One investment vehicle that has garnered attention is the convertible bond. A convertible bond is a bond issued by a publicly traded corporation that gives the bondholder the option to convert the bond to a certain number of shares of the corporation’s common stock at a specific price. Convertible bondholders are essentially creditors of the issuing company who have the right to become owners.

Convertible bonds are not a new investment product and, in fact, became popular in the latter part of the 19th century when the railroad and telephone companies used them as a means of financing their expansion. One of their primary advantages includes the ability to capture additional profits should the stock price rise above the conversion price. If the stock does poorly, you have the safety of owning a bond and collecting interest. As with all financial products, advantages come at a price. You will receive a lower yield than you would for a comparable non-convertible bond, so if you never convert to shares of stock, you have earned a sub-par return. Also, many convertible bonds are callable at the option of the issuing company at a price that effectively limits your profit potential should the stock price rise significantly.

Analyzing which convertible bonds to purchase is a daunting task for most investors since it requires an in-depth understanding of bonds, stocks and corporate analysis. Your best bet is a convertible bond fund run by an experienced money manager. Consider no-load Vanguard Convertible Securities (VCVSX) run by manager Larry Keele, whose fund currently yields 3.8%. Convertible bond pioneer, John Calamos, along with his nephew, Nick Calamos, manage the Calamos Convertible fund (CCVIX), which currently yields approximately 3.1%. This load fund can be purchased on a no-load basis through Charles Schwab & Company.

Are convertible bonds or bond funds an appropriate investment for the individual investor? Sometimes referred to as ‘chicken stocks’, convertible bonds can provide risk adverse investors a way to participate in the often volatile stock market while reducing risk. However, the risk profile for convertible securities more closely resembles stocks. Take a look at the recent stock market extreme volatility for calendar years 2008 and 2009. For 2008, the stock market was down 37%. Vanguard’s and Calamos’ convertible bond funds were down 29.79% and 25.88% respectively. In 2009, the stock market rose 27% and these funds also rose 40% and 34% respectively. Convertible bonds are not for everybody but they are a valuable investment tool to add to your toolbox. Based on the recent stock market run-up since the March 9, 2009 lows, a lot of the short-term profit potential may have been wrung out of this strategy, so consider waiting on a market pull-back or plan on a long-term investment.

Stewart Welch