Educational Programming Video
The Value Line Convertibles Survey
Program 3: Why Companies Issue Convertible Securities
In our last session, we covered the structure of traditional convertible securities and defined some common terms used in the convertibles market. In this lesson, we'll look at the rationale behind why companies choose to issue convertible securities instead of straight bonds or equity, why convertibles are considered safer than common stocks and why you may want to buy convertible securities instead of common stocks.
Capital financing through the issuance of convertible debt can be more advantageous for a company than an issue of straight debt or equity. The fact is, most convertibles are converted, turning debt into equity. Companies issue convertibles as a cheaper source of raising capital. Convertible debt normally comes to market at a lower rate than the prevailing interest rates. From the issuer's viewpoint, convertible debt can either be an alternative to equity or an alternative to the issuance of straight debt. As an alternative to equity, if the debt is converted, the result is that the company sold shares at a price higher than that obtainable through a direct issue of common shares. As an alternative to debt, the convertible has a lower probability of being converted but when redeemed, the company would have raised capital at a much lower cost than a straight debt issue.
Why convertibles are lower in risk than stocks is easy to understand. First, they are of higher quality than common stocks. If a company's earnings decline, it might skip its common dividends, but it would discontinue paying bond interest or preferred dividends only as a last resort. For if it did, bond and preferred holders might be able to take control of the company. Furthermore, if a company did fail, bond and preferred holders are ahead of common shareholders in line for the company's assets. In addition, in almost all cases, convertibles will offer a higher yield than stocks. So, if the price of the common falls, the higher yield helps to support the bonds and preferreds. What this means is that fairly priced convertibles are always "favorably leveraged." Leverage describes the price movement of one issue relative to another. A warrant is highly leveraged: it will rise much faster than its underlying stock. A convertible almost always moves more slowly than its underlying stock. An issue is described as being "favorably leveraged" if it will rise more on a rise in the underlying stock than it will fall on a decline in the stock. Convertibles are favorably leveraged since they are free to participate in a rise in the stock, but their higher yields limit the extent of any drop. Hence, they often have a better reward/risk profile than the stock.
Over the years, studies have shown that convertibles can outperform common stocks over extended periods of time, five years or more. Why this should be so is best explained if we look at what happens in various phases of the market. When the market falls, it's easy to see that convertibles will do better than stocks. Not only will they probably fall less, but they also provide greater income. In a flat market, their greater income is the deciding factor. In a rising market, convertibles do not normally appreciate in price as fast as the common, but if the market rise is slow, the greater income from convertibles causes the total return from convertibles to equal or sometimes exceed the total return from common stocks. Only in a rapidly rising market do convertibles lag behind common stocks.
However, before jumping into convertible investing, there are a few common misconceptions I want to clear up. The first has to do with prices. Do you think that a convertible, which was a good buy last week at 100, is even a better buy at 98 this week? Not necessarily, since fluctuations in the underlying stock price can have a major impact. Let's say the stock last week was $20 and fell 15% to $17 this week. Unless the convertible has a very high investment value, it is almost certain that on a risk/reward basis the convertible would be less attractive at 98 than it was at 100. However, if the stock remained unchanged, the convertible might be a better buy at 98. [Note: Bond prices are quoted as a percentage of $1,000. So, a bond price at 100, really means $1,000.00 and 98 would mean $980.00.]
Another has to do with yields. There is a misconception that if a convertible yields less than its common stock, it should be sold or converted. Sometimes this is so, but not always. It should be remembered that convertible securities are senior to common stocks and their payouts are more assured than common dividends. If a company's financial strength weakens and it looks like common dividend may be interrupted, investors should hold on to the convertible. Only if the common dividend is secure and its yield is likely to be consistently higher than that of the convertible, should convertible holders think of converting or selling.
There are other misconceptions about convertible investing which are beyond the scope of this report. But we will clarify these at a later date.
We hope our sessions are enlightening and hope that you will be back for our discussion on how to choose convertibles depending on market conditions.