Educational Programming Video
The Value Line Convertibles Survey
Program 4: Selecting Convertibles
In this session, we will focus on how to select convertibles for different market and interest rate environments.
The guidelines we provide are intended to help you select the best convertibles to meet your specific investment objectives. Before purchasing any convertible, you will want to answer some basic questions. For instance, is the bond callable? Is it fairly valued (or priced) relative to the underlying stock? Does it provide sufficient income? What are the prospects of the underlying stock?
If a convertible satisfies your requirements in these areas, you will want to find out whether the issue is sensitive to, or insulated from, movements in the underlying stock and changes in interest rates. Here are our suggestions for investing in a variety of market and interest rate scenarios.
Rising Equity Market/ Falling Interest Rates: This is an ideal situation for convertibles. In this type of market environment, both markets are moving in a direction that will boost a convertible's price, barring weakness in an individual company. In this scenario, issues with low premiums over conversion value or investment value--or both--are ideal.
Rising Equity Market/Flat Interest Rates: Issues with a low premium over conversion value are desirable to take advantage of rising equity values. Moderate premiums over investment value are preferable, since interest rates are expected to remain stable.
Rising Equity Market/Rising Interest Rates: The magnitude of the interest rate change and whether or not it is a minor fluctuation, or a major trend, play an important role in positioning a portfolio for this scenario. Minor fluctuations in interest rates will always occur and provide good buying opportunities so long as they are merely fluctuations. However, it is unusual for equity markets to make a sustained rise when interest rates are increasing, since higher interest rates enhance the attractiveness of the fixed income market as an equity market alternative. Still, if this type of market were expected to endure, a low premium over conversion value would be desired to take advantage of the rising equity market, and a high premium over investment value to limit sensitivity to the bond market.
Flat Equity Market/Falling Interest Rates: Declining long-term interest rates boost convertibles with low premiums over investment value. A low premium over conversion value is not a prime requirement since equity markets are expected to remain flat. Eventually, however, falling interest rates often lead to higher equity markets.
Flat Equity Market/Flat Interest Rates: Moderate premiums over conversion and investment values would be in order when both markets are expected to remain flat.
Flat Equity Market/Rising Interest Rates: If the outlook is for interest rates to go up, emphasis should be placed on convertibles with high premiums over investment value.
Falling Equity Market/Falling Interest Rates: This type of market is rare, or at least temporary. Lower interest rates will normally boost stock prices as investors pursue the higher returns equities can offer. The fixed-income portion of convertibles should do well in this type of environment. One would therefore select issues with low premiums over investment value and high premiums over conversion value.
Falling Equity Market/Flat Interest Rates: Here, the emphasis would be on issues with high premiums over conversion value and low premiums over investment value, reducing the sensitivity of the portfolio to the equity side.
Falling Equity Market/Rising Interest Rates: Most convertible investors view this type of market as a worst-case scenario for convertibles because downward pricing pressure is placed on both components (bond and warrant) of the convertible. This would be an ideal time for investors to consider other strategies, such as hedging. In addition, issues should be selected on superior creditworthiness, focus on industries that are likely to do well, and look for issues that have high yields and short maturities that will support the basic investment value.
In general, there are three features of a convertible that will determine how well a bond will respond to changes in interest rates; time to maturity; coupon rate, and quality. Therefore, you can position your portfolio to your interest rate outlook as follows:
For falling interest rates: Increase sensitivity by choosing issues with more time to maturity, lower coupon and lower quality.
For rising interest rates: Reduce sensitivity by choosing issues with less time to maturity, higher coupon and higher quality.
That concludes our session for today. Next time, we will deal with the various types of convertibles and in particularly zero-coupon convertible bonds.