Investing in Convertible Stock for Income (Barrons)

Feature | SATURDAY, DECEMBER 31, 2011


Stocks with Training Wheels
By ANDREW BARY

Funds are the best way for individuals to play convertible securities. But some big and liquid issues are worth a look. Think MetLife and Wells Fargo, which sport yields of 7% or more.

Convertible securities finished an uncharacteristically bad year in 2011 with returns that trailed the Standard & Poor's 500 index. That could set up converts for a strong 2012 because major issuers like General Motors and Citigroup that contributed to the disappointing showing in 2011 now carry low valuations relative to earnings and could rally this year.

"Converts are a great way for investors to play a rebound in some out-of-favor companies and collect some income along the way. They offer a highly attractive alternative to the common stock," says David Hulme, a managing director at Advent Capital Management, which runs two convertible closed-end funds, including the Advent Claymore Convertible Securities Fund (ticker: AVK).

Convertible bonds can be swapped for the issuer's common stock, giving investors upside participation. They now offer only half the appreciation potential of the common, but provide better downside protection if the common declines. The average convert pays 3.5%.


Warren Buffett, for one, is a fan of the market; Berkshire Hathaway owns a large convert from Dow Chemical.

Toward the end of last week, the $200 billion U.S. convert market was down 5% in 2011, based on the BofA/Merrill Lynch index, versus a 2% total return for the S&P 500. Prior to 2011, converts typically bested the S&P 500 in good markets and bad. While converts didn't have great absolute performance in 2011, they did their job in protecting investors because the stocks underpinning convert issues dropped about 12%, Hulme notes.

Converts come in several varieties and their complexity can be daunting with such features as shifting exchange ratios. The complexity factor has been a turn-off for retail investors, who've never embraced the market and typically have invested via funds rather than directly. The largest investors are hedge funds that buy converts and sell short the underlying stocks.

As the nearby table shows, there are four main ways to play the sector: open-end funds, closed-end funds, exchange-traded funds as well as individual issues, many of which trade on the New York Stock Exchange.

There are more than a dozen open-end funds run by the likes of Fidelity, Vanguard, Columbia, Franklin, Calamos, PIMCO and Mainstay. They generally yield around 4%.

Closed-end funds typically yield more, thanks to several factors, including leverage, which increases share-price volatility. Some funds, like the Calamos Convertible and High Income Fund (CHY), try to maintain high and steady dividends, even if it means returning some of investors' own capital. There's one sizable exchange-traded fund, the SPDR Barclays Capital Convertible Fund (CWB). It trades around $36 and yields 4.6%.

Citigroup (C), GM (GM), Wells Fargo (WFC), Bank of America (BAC) and MetLife (MET) have Big Board-traded convertible preferred shares. The Citi, MetLife and GM issues are mandatory converts, which are complex securities that will be automatically exchange for common stock, with the Citi issue due for conversion in late 2012.

Hulme likes the Citi issue, now trading around $82, because it has a high yield of 9%, versus just 0.2% on the common, and trades at a discount to its equity value. The GM preferred, with nearly two years to maturity, now trades around $35, a premium to its equity value of around $30. This is derived by multiplying GM's stock price of $20 by the conversion factor of 1.51. It yields 7% and good upside participation if the stock rallies. If GM common gets back to its 2010 IPO price of $33, the convert should rally to $50, a 43% gain.

The Bank of America and Wells Fargo preferred are known as "busted" converts because their conversion features are way out of the money. They amount to yield plays. The Bank of America 7.25% convert trades at $770, a deep discount to its face value of $1,000, and yields 9.3%. One believer in the safety of the preferred dividend is Buffett because Berkshire bought $5 billion of Bank of America 6% preferred in August.

The Wells Fargo 7.5% issue trades at $1,060, a premium to its face value of $1,000, and yields about 7%, a fat yield considering the bank's financial strength.


Convertible Opportunities

OPEN-END FUNDS Size (mil) Return YTD Yield
Fidelity Convertible/FCVSX $1,980 -7.5% 3.5%
Columbia Convertible /NCIAX 510 -4.9 3.3
PIMCO Convertible /PFCIX 1,600 -2.8 5.4
Vanguard Convertible/VCVSX 1,680 6.8 4.4
YTD Discount
CLOSED-END FUNDS Price Return Yield Discount to NAV
Calamos Convert & Hi/CHY $11.8 9 0.5% 8.9% -4%
Advent/Claymore Convert/AVK 15.13 -9.4 7.6 -9
Putnam High Income/PCF 7.71 -1.9 6.8 -1
INDIVIDUAL CONVERTS Price Yield Convert Type
Citigroup 7.5% Preferred/C Pr H $82 9.3% Mandatory
GM 4 3/4% Preferred/GM Pr B 34 6.9 Mandatory
Bank of America 7.25%/BAC Pr L 768* 9.2 Regular
Wells Fargo 7.5%/WFC Pr L 1,050* 7.1 Regular
ETF Price Return YTD Yield
SPDR Barclays Convertible/CWB $36 -7.9% 4.6%

*$1,000 face value Source: Bloomberg; CEF Connect
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