June 18, 2019
One of my more exhilarating memories is riding in a hot convertible with the top down and the sound of a great engine with the wind in my hair. No music required. As a kid growing up in Palo Alto, Mom and Dad drove us around in a baby blue 1957 Chevy Bel Air convertible with dual antennas. Somehow when you’re cruising in a ride like that, heading down to the Rexall drugstore soda fountain for a root beer float, there’s not a worry in the world that can steal your joy in the moment. Not a chance.
This “top down, wind in your hair” attitude is how I would best describe the stock market of late. Despite the ongoing trade war with China, the slow train wreck of the European Union under way, unhinged toxic political rhetoric on Capitol Hill, trap-door tweets and unbearable gloom and doom in the financial media, and the slowing U.S. economy, most Americans feel pretty good about their “present situation.”
Specifically, the reading on consumer confidence came in at 134.1 for the month of May, when markets were falling. The last time consumer confidence was this high was back in 2000, nearly a generation ago. When the unemployment rate is down to 3.6%, wages are rising at a rate that matches inflation, and the Fed is telegraphing two or three upcoming rate cuts, it’s no wonder we’re seeing more convertibles on the road. It’s the American way! Prosperity breeds more sales of convertibles and trips to the soda fountain, which today translates into hitting the neighborhood Starbucks for a Vanilla Bean Crème Frappuccino.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Why am I talking about convertibles? Since this is a column targeting income in a world where yields are crashing, I want to examine the convertible securities sector since market conditions now favor this asset class: Interest rates are trending lower with stocks trading higher. These catalysts are what convertible securities thrive on and yet most investors have limited or no knowledge of the convertible market.
As the market is affected by a variety of forces – interest rates, inflation, rising and falling GDP rates, and volatile energy prices – it just makes sense to be flexible. Right now, this means we should be willing to move into the right asset classes when the investing landscape characteristics change.
A convertible security can be either a convertible bond or a convertible preferred stock. Very simply, a convertible bond or preferred stock can be converted into a company’s common stock at a given strike price. That means you can exchange the bond for a predetermined number of shares. The conversion ratio is tied to the number of shares the debt instrument is being converted into. For example, a conversion ratio of 40-1 means that every bond of $1,000 par value you hold can be exchanged for 40 shares of stock.
Convertible bonds typically pay 2% to 4% yields and they also typically offer a lower yield than regular bonds, because there is the option to convert the shares into common stock and collect the capital gain.
A convertible preferred stock has features similar to a convertible bond, but it is subordinated to the convertible bond debt of the issuing company. It typically offers a coupon of 3% to 6%. A convertible preferred will normally pay a quarterly cash coupon. It is perpetual or has a long maturity, like 25 years.
Convertibles are an excellent choice for investors looking for capital appreciation, but who also want to protect their original investment in a bond equivalent. One risk associated with convertibles is that most are “callable.” In other words, the company can force convertible bondholders to convert the bonds to common stock by calling the bonds — referred to as a “forced conversion.” If the company’s stock falls to a price that makes the convertible feature of the bond worthless (as long as the company is solvent), the bond will trade based on its yield just like any other bond. There is a price level to which a bond will drop and then fall no further, as long as the company can pay its interest and the principal upon maturity.
If a $1,000 convertible bond is convertible into 50 shares of stock, the parity price of the stock is $20. If the stock moves up to $25, then for the stock and bonds to remain at parity, the bonds would have to be trading at $1,250. Thus, a convertible bond can provide the performance attributes of common stock and a bond. This is like having your income cake and eating it too.
Buy Your Own Convertible (car) With Your Convertible Profits
The upside of the convertible bond comes from its common stock component, while downside protection comes from its cash coupon, fixed maturity, and its capital status, which is senior to common stock. The bottom line is that convertible bonds and convertible preferreds are paid before common stock dividends.
The most common method for buying convertible securities is to use a broker, either full-service or discount. The minimum investment for a convertible is typically $1,000 — the price of one bond. Convertible preferred stocks trade like regular shares, so the prices usually range from $25 to $100.
I like the convertible securities market because it addresses the desires of both bond and equity investors. For equity-oriented investors, convertibles can be viewed as a stock with a put option. The upside of the convertible comes from the underlying stock. The higher the price of the underlying stock goes, the higher the convertible price should go, without sacrificing the security of downside protection.
A convertible can also be viewed as a bond plus a call option. In this case, the upside of the convertible comes from the call represented by the conversion feature. Moreover, the downside protection also comes from the bond attributes of the security, including the generally higher-yield, fixed-maturity value.
Either way we have an asset designed to pay a handsome yield in a relatively safe investment vehicle with excellent upside potential. A few examples of widely-held convertible debt securities within some of the closed-end funds that pay current yields of 3% to 6% include:
Wells Fargo 7.5% due 12/31/2049
Bank of America 7.25% due 12/31/2049
Becton Dickenson 6.125% due 12.31/2049
Sempra Energy 6.00% due 12.31/2049
Crown Castle 6.875% due 12/31/2049
Navellier & Associates does not own Wells Fargo, Bank of America, Becton Dickenson, Sempra Energy, or Crown Castle in managed accounts and our sub-advised mutual fund. Bryan Perry does not own Wells Fargo, Bank of America, Becton Dickenson, Sempra Energy, or Crown Castle in personal accounts.
These companies and others of similar quality have pristine balance sheets and are instruments of choice with investors like Warren Buffett. It’s how they get paid like a champ until the underlying stock gains in value to a point where converting the bond or preferred stock into common shares makes financial sense.
While I rode around in a 1957 Chevy Bel Air ragtop – now long out of production – I think the folks at GM have done a nice job with the 2019 Chevy Camaro convertible. When my four-month old grandson is able to enjoy his first root beer float, I’m looking forward to throwing the top back and sharing the same good time I had as a kid heading to the soda fountain – paid for in part with convertible securities.