A Quick Course on Convertible Bonds

Course on Convertible Bonds

 

No Many savvy investors look to convertible bonds as an attractive alternative to common stock. Convertibles can be exchanged for common shares in lieu of repayment of the note signified by the bonds. They generally yield more than the underlying common and provide nearly as much upside potential as the common with less risk.
One drawback: Convertibles usually sell at a premium over the conversion value (the value of the common shares into which they may be converted) because of the higher yields.
What to look for: Situations do occur where the common provides the higher yield and/or where the bond is selling so far above par value that its yield has become relatively insignificant. As a result, convertible bonds may be selling close to or even below their actual conversion value.
Investors familiar with convertible opportunities may be able to take advantage of such situations by following this procedure:
Before purchasing common stock, check to see if convertibles either at conversion value or below happen to be available. Please read this also: Buying Treasury Bills: An Advice
If you purchase convertibles at conversion value, you will save on commissions. And if you buy below conversion value (rare, but sometimes possible), you will have purchased the underlying common at an effective discount: The differential between the bond’s conversion value and actual price.
If the common provides a higher yield than the convertible bonds, have your broker submit the bonds for conversion (which usually takes two to three weeks). You will then be holding the higher-yielding common, purchased at a discount. Warning: Don’t submit the bonds for conversion until immediately after the next interest payout, unless the payout has just passed. Bondholders lose accrued interest upon conversion. Most bonds pay interest semiannually.
Buying advice: Don’t place “market orders” for convertibles. Bond markets are thinner than stock markets, and you can be hurt by a wide spread between the bid and asked prices. Place definite limit orders.

Profiting from Junk Bonds

Institutional investors generally ignore junk bonds, which is why prices are low. 
 
Reasons
(1) Pension-fund managers stay out because they’re investing conservatively for people’s retirement. 
 
(2) The volume of junk bonds is limited, and institutional investors with massive cash inflows to invest find that they distort the market and ruin profitability by making large purchases. (Small purchases aren’t worth their effort.) 
 
(3) Institutional investors often abandon lower-paying junk bonds during periods of rising interest rates to take advantage of higher yields on more recent issues.
When to buy: The best time is when interest rates are peaking. As interest rates drop, low-yielding junk bonds become relatively more attractive and prices tend to rise quickly.
Who benefits from buying junk bonds: People with as little as $25,000 to invest as speculative capital. Risks: Junk bonds derive their name from their poor rating, and the specter of default scares many people. Should the recession become severe, the dangers are multiplied, But junk bonds are safer than appear.

The evidence

(1) In the past 20 years, less than 3% of all junk bonds have defaulted.
 
(2) When default is imminent, senior creditors (banks, insurance companies, etc) usually defer their claims or settle for much less to keep the company out of bankruptcy Junior bondholders, in practice, almost always come out with full payment
(3) Many junk bonds are issued by America’s top corporations, which may experience hard times but aren’t likely to go bankrupt Strategy for investing in junk bonds
Diversify Spread a $25,000 investment over five to ten issues Pick bonds where the discount is due to
lower yield and not the risk of insolvency. Look for bonds trading at the lowest prices (Note: Junk bonds are traded on the New York and American Bond exchanges. Remember to add a zero to quotes when figuring the price.)
Avoid issues where the government might intervene, (Example Railroads, airlines, and municipalities Stay away from the real estate investment trusts EITs) because they are liquid and hard to figure out.
Rule of thumb If the junk bond has a ten-year maturity, assume the price ought to rise by 10% a year. Sell the bond if the price rises by 20% in one year and reinvest in something che-unless attractive interest rates make the bond worth holding longer. Buy more bonds if the price falls, because the return on investment at maturity will be that much greater.
Important: Junk bonds are discounted because the company’s rating isn’t very good Don’t expect to hear good news about the Company Don’t get cold feet and sell out if the price begins to fall. 
Bond-Buying Strategy
The classic bond buying opportunity when interest rates drop Investors can lock in high yields and defer interest income, too. One study calculates that 20-year, AAA-rated industrial bonds rose an average of 15.6% during five interest rate swings. These swings, from peak to trough, usually lasted for about one-year Conservative strategy: AAA-rated corporate
or Treasury issues. Aggressive strategy: Lower-rated issues that swing more in price, providing greater tax deferral (and greater risk). However, even speculators avoid bonds rated lower than A when the depth of the recession is not completely clear.

When to Avoid Bond Mutual Funds

Bond mutual funds, either corporate or municipal bond funds, are probably not a good deal unless the management fee charged by the fund is very low (2 % or less). They do provide diversification, but for most investors buying the bonds directly through a broker is cheaper.
 
The one-time sales commission on a purchase of $25,000 worth of bonds is about $125. Fund annual management fees can be as much as $250/year on same-sized purchases. Exception: Money market funds provide more services and are worth the fees.
 
Don’t forget to learn: How to Use the Daily Stock Charts
 
Source: The Only Investment Guide You’ll Ever Need by Andrew Tobias, Harcourt Brace Jovanovich, New York

 

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