A Practical Guide to Investing Safely and Wisely Should I have convertible bonds in my portfolio?

Richard W. Wiegand Founder ProActInvest.net

A video version of this chapter is available on the ProActInvest.net YouTube channel or by keying in this URL: http://www.youtube.com/watch?v=3z5bMSnPg1E

Welcome to an important strategy session on investing sponsored by ProActInvest.net with Richard Wiegand entitled, Should I have convertible bonds in my portfolio? This lesson is downloadable on the ProActInvest.net web site as a pdf document as well as a video tutorial and is one of the chapters in the E-book entitled A Practical Guide to Investing Safely and Wisely. We welcome your questions and feedback via comments on the ProActInvest.net web site as well as on Facebook (please Like us on our Facebook page) as well as Liking us on YouTube!

What we ll cover in this lesson:

What are convertible bonds? What are the advantages and disadvantages of converts? How have convertible bond funds done compared to some of my favorite core allocation bond funds? Is there a need to get direct exposure to converts? The bottom line summary and concluding remarks

Let s review some of the key questions that we ll be covering in this strategy lesson: Convertible bonds are just one among many investment choices. We have to understand what they are and what makes them tick before we consider investing in them, either directly or through mutual funds or ETFs. (Yes there are ETFs that are comprised solely of convertible bonds). We have to also review how this bond sector has performed compared to other bond funds based on historical data to determine whether it s really worthwhile going down this route.

Convertible bonds are hybrid securities

subordinated bond
(with slightly lower yield than non-convertible bonds)

with stock exposure

(to participate in the upside value of the issuing firm)

Convertible bonds (converts or CVs for short), are hybrid securities they are part bond and part equity call option. Like most corporate bonds, converts typically /pay semi-annual interest based on a coupon rate until the maturity date, at which time the principal is repayed to bond owners in full. The coupon rate for converts is actually noticeably lower than for non-convertible bonds because the company is granting the convertible bond holder the privilege (or right) to convert the bond into shares of common stock at a pre-determined (usually higher than current) price per share for the life of the bond. In effect, this right to convert into common shares is an equity call option. So convertible bonds may be viewed as being a lower yielding corporate bond combined with an equity call option on the company s common shares, a contractual agreement that is valid until the maturity date of the bond. In return for a somewhat lower yield on the bond, the company issuing the convertible bond is giving the bond holder the ability to participate in the potential upside in the value of the firm (assuming that the stock price rises over time).

Convertible bonds give investors the right to exercise their right to convert their bonds into shares of common stock at a pre-determined price/share.

Advantages of Convertible bonds for Issuers

 lowers financing costs for the company

(lower coupon rates on bonds in return for giving investors equity upside participation)  the company can raise more capital than with a direct rights issue because potential EPS dilution may drive common stock price downwards, unless the stock rallies

Why do these hybrid securities exist? How and why were they developed? They exist because they offer specific advantages to companies that issue them. If a company wants to raise capital to help pay for an expansion or for everyday operating expenses, convertible bonds offer cheaper/lower financing rates than non-convertible bonds because of the equity conversion (call option) privilege given to bond holders. The farther out the maturity of the bond, the more time value the call option has and the lower interest rate the company has to pay for borrowing money. The company is not diluting the common shares outstanding by issuing convertible bonds because the equity options attached to the convertible bonds are exercisable on existing (i.e. already issued) common shares of stock. Therefore, the earnings per share and ownership value per share of the company are preserved they are not diluted.

Advantages of Convertible bonds for Investors

 privilege of a senior security because it s a bond, not stock  higher coupon rates than dividend yield from stocks  participate in upside potential of the firm value through conversion privilege  total returns are 2-4% higher from convertible bond funds than with typical investment grade bond funds  converts are generally more liquid than non-convertible bonds

From the investor s perspective, converts offer the protection of a senior security. If the company should go belly up, bond holders get a piece of the carcass before equity shareholders do and that includes convertible bond holders. Coverts are subordinate, however, to senior indentured bonds. Convertible bonds have higher coupon yields than the dividend rate on the common shares (if a dividend is even paid), and as we said, also participate in the upside value of the firm should the stock price rally over time. Because of the equity component, the average annual total return of convertibles is about 2-4% higher than your typical investment grade bond fund. Convertible bonds are also more actively traded than your average corporate bond making them more liquid. However, as I mention in another ProActInvest.net lesson on investing, I totally discourage investors from buying individual bonds. It is much safer and more prudent to get the diversification that a well-managed bond fund offers than to try to construct and manage a portfolio of a handful of individual bonds.

Disadvantages of Convertible bonds for Investors

 lower yields than non-convertible bonds  3 times as volatile as most investment-grade bond funds  2 times as volatile as most high yield bond funds  extra volatility of equity component reduces reward/risk ratio to unfavorable levels when compared to other bond funds or optimized bond/stock fund allocations

The disadvantages are quite significant, however. First, because of the equity call option privilege, converts pay a lower interest (or yield) than non-convertibles. But the major negative for converts is that they behave more like stocks than bonds and so exhibit about 3 x as much volatility (downside risk) as plain vanilla investment-grade bonds and 2 x as much risk as high yield corporate bind funds. Let s step back and have a look at a total return chart from Morningstar.com that compares Vanguard s convertible bond fund with Vanguard s S&P 500 index fund and Vanguard s intermediate investmentgrade bond fund.

The practical question is: do converts behave more like stock (equities) or more like bonds? A fast and easy way to answer this is to go to Morningstar.com and overlay the total return performance (dividend plus capital gains/losses) of a convertible bond index fund (Vanguard s convertible securities fund, ticker VCVSX), with the S&P 500 (Vanguard s S&P 500 index fund, ticker VFINX) and with an intermediate bond index fund like Vanguard s VFIIX. When we do this you can clearly see that convertible bond funds actually behave more like equities than bonds! The blue line is more correlated with the orange line than with the green line (the blue line moves more in sync with the orange line than with the green line). This should raise a red flag to investors because stocks are about 4 x as volatile as investment grade bond funds. So right off the bat we know that we have to be very careful with this type of animal. Converts are not be the silver bullet for our portfolios after all. In defense of converts however, we notice that they did rebound better from the depths of the financial markets meltdown in 2008 than the overall stock market (compare the blue line with the orange line). But the investment-grade bonds (green line) hardly did not suffer any harm during the meltdown of 2008 and finished virtually as high as converts did by the end of 2011!

Convertible bonds have a risk factor comparable to equities

Here is another chart from Morningstar.com showing the high correlation that convertible bond funds have with stocks. The only reassurance was that convertible bonds (VCVSX) bounced better off the lows than stocks (the S&P 500) did, after having dropped about as much as the stock market in 2008.

Convertible bonds have a risk factor comparable to equities

 in 2008, convertible bond funds lost about as much value as the S&P 500  S&P 500 was down -37% in 2008  VCVSX (Vanguard s convertible bond index fund) was down -34.8%

How bad exactly was the fall in value in for 2008? While the S&P 500 lost -37% of its value, the Vanguard convertible bond fund was down -34%. Meanwhile, investment-grade bond funds actually made anywhere from +5 to +13% in 2008, depending on how much U.S. Treasury exposure it had! The bottom line is that convertible bond funds do not preserve capital in equity bear markets, and they are about as risky as stocks.

Convertible bonds have performed about the same as high yield bond funds but with much more risk!

Over the past 10 years, convertible bond funds performed about as well as high yield bond funds but dropped about -9% more than high yield bond funds did in 2008. The risk for convertible bond funds in terms of annualized standard deviation (a measure of volatility) is 16.6% vs. 11.6% for high yield bond funds. So if convertible investors ended up with about the same amount of money as high yield bond fund investors but had to suffer through an extra 5% of volatility the question becomes are convertible bonds really worth the added risk?

There are better bonds funds out there with less risk...

In the chart above, we once again see the historical performance of the Vanguard convertible bond fund (VCVSX) as the blue line vs. the Vanguard high yield bond fund in yellow (VWEHX), the Vanguard S&P 500 stock index fund (VFINX) in orange and the Loomis Sayles bond fund in green (LSBRX). Notice how the Loomis Sayles bond fund which is a five-star managed blend of investment-grade and high yield bonds out-performed all of the other funds on the chart and suffered significantly less drawdown in the meltdown of 2008! There are a few other bond funds like Loomis that I can recommend as well, but none have the equity-like juice that Loomis offers. In equity bull markets, Loomis ups its exposure to bond sectors that have more equity-like characteristics - like convertibles and high yield debt but never to the point where they dominate the overall mix. Indeed, Loomis offers exposure to convertibles but it rarely exceeds 10% of the overall bond portfolio. High yield debt is also kept in check so that a base of around 70% of the portfolio is always in safer medium duration (i.e. 4-8 year maturities) investment-grade bonds. Thus, Loomis offer a well-managed, flexible solution for conservative investors who don t want to lose their shorts in bear markets but who still want to benefit from bull market rallies.

This table compares and ranks conservative (plain vanilla) investment-grade bond funds with those with increasing equity exposure. The more equity-like characteristics (as in the case of high yield debt and convertible bond funds), the higher the risk. Based on historical data for the S&P 500 stock index going back to 1926, stocks have an annual standard deviation of 20.2%, about 4 times that of the Barclays Aggregate Bond index. Convertibles come quite close to pure stock risk at 16.6%. The Quick Sharpe ratio is useful for gauging the amount of reward you get for each and every ounce of risk that you take. As this tables shows, investment-grade bond funds have some of the highest reward/risk ratios you can get. This is true across all the major asset classes (stocks, bonds, commodities, real estate) as well. The only major drawback is that the average annual rate of return for investment-grade bonds is only 6.1%, which is only 3.0% greater than the historical rate of inflation in the U.S. of 3.1% So we need a little extra kick which you can get from bond funds that pay higher yield (but also have higher credit risk), or by having exposure to bonds with equity features like convertibles. Or, you can choose to invest in a fund like Loomis Sayles (LSBRX), whose managers know how to get the right mix of safety and higher yield and/or equity upside. Longer-term investors definitely want to have more equity exposure and higher yield than investors with a shorter time horizon, but as you will see in later lessons, you should not raise your equity exposure with either stock funds or bond funds that have equity exposure beyond a certain manageable percent. In later chapters, I will show you just what this equity allocation percentage should be and which funds to choose.

This bar chart shows the average annual percentage returns (the black lines) for all the bond funds that we discussed in this lesson but also shows their best and worst annual performances since inception. As you can see, the riskier funds generally have the widest ranges. As with the Q Sharpe ratio (that measures reward/risk), investors want to get as much green (positive years) with as little red (negative return years) as possible. At the same time, investors must try to out-perform the rate of inflation in order to generate real returns. Based on these reward/risk measures, which bond fund would you opt for?

Bottom line: You don t need a direct investment in convertible bonds /funds
 There are other investment grade bond funds that perform even better but with much less risk (LSBRX e.g.)  These funds already allocate a small percentage to converts, so no need to buy a fund that specializes in them  Like convertible bond funds, high yield bond funds also have high equity correlation but outperform converts on a reward/risk basis

The bottom line is that investors are advised not to invest directly in convertible bonds or bond funds. Reward/risk ratios comparisons show that there are better options available. While the Loomis Bond Fund (LSBRX) is riskier than the Janus Flexible bond fund or the Barclays Aggregate Bond index, it does generate an average annual rate of return of around 10%, which is outstanding for a bond fund that typically holds close to 70% of its portfolio in safe investment-grade bonds. The rest is invested in higher yielding debt securities, preferred stock, and/or convertible bonds. At the time of this report, about 10% of Loomis is allocated to convertible bonds. The point is that a diversified (predominantly) investment-grade bond fund like Loomis will give you the equity exposure and higher yield that longterm investors need and it does so within the right proportions. I am not suggesting that investors allocate everything to Loomis, because I recommend that you balance LSBRX with a more conservative fund like Janus Flexible (JAFIX) or the Barclays Aggregate index (AGG), while allocating a small percentage to stock funds. I will cover my suggested all-weather long-term investment portfolio in a subsequent chapter in this book, which will have the recommended weightings for each fund.

A Practical Guide to Investing Safely and Wisely Should I have convertible bonds in my portfolio?

Richard W. Wiegand Founder ProActInvest.net

That concludes this chapter of the book A Practical Guide to Investing Safely and Wisely on convertible bonds.

A video version of this chapter is available on the ProActInvest.net YouTube channel or by keying in this URL: http://www.youtube.com/watch?v=3z5bMSnPg1E

If you enjoyed this strategy session, please help spread the word to your friends on Facebook, Twitter, StumbleUpon, by e-mail or word of mouth! Remember to check out our upcoming E-Book on investing with complementary video webinar series!