Convertibles provide way to minimize risk
BY TERRY SAVAGE SUN-TIMES COLUMNIST Jul 14, 2006
Updated: May 3, 2013 12:14PM
Originally published: Jan. 6, 2002
Convertible bonds and convertible preferred stocks are among the least understood investment categories--and therein lies the extra potential for maximizing profit while minimizing downside risk. John Calamos, president of Chicago-based Calamos Asset Management, has made a career out of doing just that. And now his five-star-rated mutual funds are attracting attention as a place to hide from--yet participate in--these volatile markets.
What are convertibles? In essence, convertible bonds are a debt obligation of a company. They pay regular interest, but offer the additional upside potential of equity, because at some point in the future these bonds may be converted into stock at a fixed price. Convertible preferred stocks work in a similar way. They pay a fixed dividend and are convertible into a specific number of shares of the underlying common stock.
The real attraction is that when the stock soars, it will bring up the value of your bond or preferred shares as well. But if the stock is trading below its optimum conversion level, you hold onto the convertible bond or preferred share in order to capture the yield or dividend.
John Calamos started trying to teach me about the mathematics of investing in convertibles more than 25 years ago--with little success, I might add. So it’s a good thing he started a series of mutual funds that use convertible bonds and preferred stocks as the basis of their investment style. That way, we can let him do the investing--something at which he has a great track record.
The Calamos Convertible Fund has a 13.1 percent average annual return over the past 10 years, and the Calamos Convertible Growth and Income fund boasts an average annual return of 16 percent over the past 10 years. Achieving better returns while lowering risk is the basic attraction of convertible securities. The risk (measured by a concept called Beta) of the S&P 500 is 1.00. The typical growth stock fund carries a much higher Beta--perhaps as high as 1.3. But the risk level of the Calamos Convertible Fund is only 0.52. And the more aggressive Convertible Growth and Income fund is still a mere 0.68. Thus, you can say the funds “beat’’ the S&P 500 over the past 10 years--with a lot less risk to the money invested.
Calamos says: “Our view is that the key to creating wealth is to manage risk. In recent months, investors have come to appreciate the risk inherent in the markets. Using convertibles is a defensive strategy that works especially well in volatile markets.”
An example: Lucent convertible preferred stock For example, the Calamos Convertible Fund has a position in Lucent Technologies convertible preferred stock. Each share of stock has a par value (the price at which it was issued) of $1,000. It pays an 8 percent dividend every year. Each $1,000 preferred share is convertible into roughly 134 shares of common at $7.48.
The stock was issued in early August, when Lucent needed to raise cash--thus the attractive dividend yield. The company might have had to pay an even higher yield if it had issued straight debt. But the conversion feature made this preferred stock issue more attractive to investors.
Today, the convertible preferred stock is selling at $1,130--a premium over its $1,000 issue price. So if you buy it today, your yield would be only 7.07 percent.
Calamos says he took a position in this convertible preferred stock on the initial offering not just for the yield, but because he believed in the fundamentals of Lucent’s business plan. But beyond that, he figures the convertible will participate in 78 percent of the upside of the underlying common stock as it rises, versus only declining 20 percent of the downside of the common stock as it falls--a very positive risk/reward ratio.
How does he calculate that ratio? That’s where the analysis gets complicated, but if you want to know more, visit his Web site at www.calamos.com. Or if you want to invest, you’ll need $5,000 to open an account in either the Calamos Convertible Fund or the more aggressive Calamos Convertible Income and Growth Fund. For more information, call 800-582-6959.
We all know by now that you can’t avoid all risk while still hoping for above-average returns. But you can minimize risk in the search for reward. That’s the reason to consider convertibles for your portfolio. And that’s the Savage Truth.
Terry Savage is a registered investment adviser and is on the board of directors of McDonald’s Corp. and Pennzoil-Quaker State Co. Send questions via e-mail to firstname.lastname@example.org.