Convertible Issues: Benefits, Risks, and Investment Considerations

Key Insight

Convertible bonds and preferred stocks have become significant in senior financing, offering investors the superior protection of a bond or preferred stock coupled with the potential to participate in a substantial rise in common stock value. Issuing companies can raise capital at a moderate interest or dividend cost, with the expectation that the senior obligation will be exchanged into common stock if prosperity materializes. However, this seemingly ideal arrangement means investors often forgo important quality or yield, while companies surrender a portion of future common shareholder enhancement, demonstrating that convertibles are not inherently attractive but depend on the specific facts of each issue.

Historical performance reveals that convertible issues floated during the latter part of bull markets tend to yield unsatisfactory results. For instance, from December 1967 to December 1970, convertible preferred stocks experienced a greater average price decline than common stocks, which lost only 5%. Comparisons with older straight preferred shares from December 1968 to December 1970 also showed convertibles performing worse, suggesting convertibles as a group possess relatively poor quality as senior issues and are tied to common stocks that underperform the general market outside speculative upsurges. The conversion privilege itself often indicates an underlying lack of genuine investment quality.

Holders of convertibles face a dilemma when profits emerge, questioning whether to sell on a small rise or hold for a larger advance, especially if the issue is called. An example involves a 6% bond bought at 100, convertible at 25 (40 shares per $1000 bond); if the stock rises to 30, the bond is worth at least 120 and sells at 125, offering a 25% profit. Despite potential gains, the practical experience often leads to substantial losses, particularly if issues fail to rise and collapse in market downturns, illustrating the general mistrust towards new convertibles and supporting the maxim: 'Never convert a convertible bond.' The ideal convertible combines strong security with an attractive underlying common stock at a slight premium, a scenario more often found in older issues.