Convertible Bonds

Convertible Bonds & Value Investing

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 bond-like 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 value investing 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. 

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IBM: Not Yet Time to Swing at this Pitch

IBM’s stock underperformance since IBM’s current CEO took the helm in 2012 has been stark, with the shares declining 23% while the S&P500 Index has more than doubled. One big problem: revenue growth rate is zero, at best. Without revenue growth, what’s left to entice investors? The real driver of value at IBM – free cash flow that is used to repurchase shares. Can IBM borrow its way to shareholder prosperity as its cash flows shrink? What to do with IBM shares? Wait for a better pitch in the form of a catalyst or much lower valuation. Read More.

Comparing Stocks Vs. Bonds

While the common stock of a turnaround candidate usually has the greatest upside potential, other classes of securities, such as bonds or preferred stock, may offer attractive profit possibilities with less risk. Many turnaround companies have only one class of securities available to investors but where there are different classes to choose from, it can pay to do a little extra analysis of the various options.

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Turnaround Letter Stock Pick Named Top Performer of 2017

 

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What Last Year's Top Stock Pickers Are Buying in 2018

 

This Forbes write-up follows up on the recent Top Stock Tips report--naming The Turnaround Letter's Crocs recommendation the top performer of 2017: With 90% gains, CROX beat out 100 other investment ideas included in the report; and the stock continues to have value investing appeal, according to Putnam.

 

George notes, "We see additional upside for the stock in 2018 as management's efforts continue to bear fruit, though the gains will likely be more muted than we saw in 2017."