Convertible Bonds
Convertible bonds are an attractive vehicle for investors who want equity-like returns but cannot bear the volatility of stocks. A convertible may also provide more current income than the underlying stock. A convertible bond is a bond that can be exchanged for stock at a certain price ratio. As a bond or a debt obligation of the company, the convertible pays you interest periodically and then pays you back your principal at maturity even if the stock declines in price. It also gets paid off ahead of the stock if the company files for bankruptcy. These bondlike characteristics usually keep the convertible from falling too far if the company has poor results.
The trouble with straight bonds is that your return is limited to the principal plus interest. And prior to maturity, straight bonds can fall in price when interest rates rise. However, a convertible gives you considerably more gain potential. If things go well for the company and the stock rises, you can exchange your convertible for stock and participate in most of the equity gains. Moreover, this equity gain potential often reduces the negative effect of a rise in interest rates.
Of course, there is no totally free lunch. From a bond investor’s point of view, convertibles usually pay lower rates of interest than straight bonds, and they are often junior in right of payment (meaning that they are less likely to get paid off if the company files for bankruptcy). From the stock investor’s point of view, the exchange rate for the stock is usually set at a high enough level that you give up some of the upside if the stock rises.
But for those willing to make these compromises to reduce volatility, Convertibles can be very appealing. Convertibles can be particularly attractive in turnaround situations, which often have great gain potential but also significant risk of loss if the turnaround doesn’t pan out. If you can find a convertible where the stock price is not too far below the conversion price, you can capture most of the gains if things go well, and your risk of loss is significantly reduced if things go badly. Read more in "Convertible Bonds: Much Of The Upside With Less Downside."
Turnaround Tips
TLCorner
Where Are the Customers' Yachts?
This headline could easily apply to Goldman Sachs today, as recently described by former employee Greg Smith. Actually, it is the title of a book written in 1940 by a former Wall Street employee named Fred Schwed, Jr. The title refers to a story about person admiring the yachts owned by bankers and brokers who asks where the customers' yachts were. Of course, the customers, who had dutifully followed the advice of the bankers and brokers, couldn’t afford yachts. This just goes to show that there is nothing new about the attitude that Goldman Sachs employees were purported (probably accurately) to have about their clients. It was just as true in 1940--and likely has been forever--as it is now.
Read More.Beware of Trendy Turnaround Candidates - Even Green Ones
Don't Chase the Headlines
The recent unfortunate accident involving the Costa Concordia cruise ship, which is owned by a subsidiary of Carnival Corp., raises an important investing question: Should you bail out of a stock if the company is affected by a serious negative event? Unless the event could be part of a series or trend, the answer is usually “no,” for two reasons.
Read More.What did The Turnaround Letter see that others did not?
Questions & Tips
AskGeorge
Now that Greece's latest bailout is complete, is it safe to buy European stocks again?
We’re not at all sure that either Greece’s or Europe’s troubles are truly behind them. But that said, we also believe that it makes sense to have some European exposure in your portfolio. The advice we gave in the November 2011 issue still holds...
Read More.With so much turmoil and uncertainty in the U.S. economy, and even more fear of collapse overseas, do you ever recommend just getting out of the stock market all together and hunkering down with something safer like bonds?
I never recommend getting out of the stock market entirely--or even making major changes to your allocation to stocks. The stock market is so unpredictable that if you bail out, the risk is very high that you will miss a significant upturn. Moreover, even if you make the right call to get out of the market, you then have to muster the courage to get back in.
Read More.What is your opinion on investing in foreign turnaround companies?
There are certainly good opportunities in foreign turnarounds, but also very significant risks as well. The market inefficiencies that provide unusually high return potential for turnarounds here in the U.S. are probably even greater in foreign markets. However, there may be special, local features that affect foreign companies that we may not understand when we view them from afar.
Read More.Bankruptcy Investing
George reflects on bankruptcy investing activity & trends seen in 2010. Read more.