Convertible Stocks And Bonds Could Be ‘95 Turnaround Play Hybrid Securities Give Investors Higher Dividends, Greater Protection If Market Sinks

They’re not animal, vegetable, or mineral.

They’re convertible stocks and bonds, hybrids that give investors some of the advantages of both - if they know what they’re doing.

After struggling in 1994, convertibles are getting renewed attention from investors who believe the worst may be over in both the stock and bond markets, but want to hedge their bets.

The Wall Street Journal explored the opportunities in a Jan. 6 “Heard of the Street” column.

In Spokane, Bank of America Vice President Ed Cassens has made a specialty out of convertibles, so much so that last fall he was given responsibility for managing one mutual fund and two trust funds with most of their assets in such securities.

He had been managing a $160 million private investment fund for the trust department of Seafirst Bank, a BankAmerica Corp. subsidiary.

The three additional funds put another $330 million in his hands.

Most of that is in the Pacific Horizon Capital Income Fund, which was established in 1987. A $10,000 investment then would have increased to $24,137 at the end of the third quarter in 1993, an average annual increase of 13.3 percent.

The same sum riding on the Standard & Poor’s 500 index would have increased to $18,000 over the same period.

Among convertible mutual funds, Pacific Horizon ranked third for the three-year period that ended in September, averaging a 15.9 percent annual return.

But Cassens notes 1994 was not a good year for convertible funds, or any other fund subject to fortunes in the bond market. An average of 31 mutual funds that invest in convertibles, calculated by Lipper Analytical Services Inc., declined 3.79 percent last year, assuming reinvestment of dividends.

Why?

Convertible bonds are just that: bonds that can be converted into common stock at a price set at the time they are issued.

There are also some convertible preferred stocks.

They pay dividends higher than those for common stock issued by the same company, so they maintain their value better in a down market. However, they will not move higher as rapidly in a bull market.

In return for the higher dividend, Cassens said, investors pay a premium over the price of the stock.

If the stock sells at $30, for example, the conversion price might be $36.

Cassens said investors should avoid convertibles with premiums greater than 30 percent.

He said would-be buyers should also be sure they can recover the premium in dividends before the issuing company has the right to “call” in the bonds in return for stock, an option that increases the company’s equity base.

Finally, Cassens said, “You’ve got to like the underlying stock.”

Cassens holds slightly more than 100 different securities in the portfolios of the funds he manages. At least 65 percent must be convertible stocks or bonds.

He buys most of the convertibles when they are first issued, when transaction costs are low and call protection at the maximum.

He usually sells when the underlying stock reaches the price at which the bond can be converted. If a company calls the bond before conversion, he said he will hang onto the stock if he thinks the company will continue to be successful.

Another strategy: buying the “busted” convertibles of companies whose stock has plunged. The yield from the convertibles gets a significant boost in such situations, Cassens said, and if the stock recovers, “You’re getting the expected conversion for nothing.”

Cassens said individuals considering individual convertibles should have a portfolio worth at least $25,000. With anything less, he recommended mutual funds.

Those who do buy convertibles should be prepared to hang onto them for a few years because most are thinly traded and may not be easily sold, he said.