Eager money (if not smart money) sometimes takes turns that are far removed from speculation in raw land, or soy beans, or arts and antiques. There has been less recent interest in convertible debentures, but they've had their flings and doubtless will once again. Convertibles - corporate bonds that can be converted into common stocks on certain fixed terms - have in the past had a lot of general appeal. Their big lure for the eager-money investor has been the fact that they always can be bought on margin.
At this writing, the margin rule is 50% as fixed by the local Reserve. This means that you can borrow up to 50% of the gross amount you pay for the debentures. Thus, when you convert them into common stock, you have bought yourself a position in the stock with a relatively small equity.
So the case for buying convertibles on margin is clear-cut. They're a somewhat cheaper way of buying into a common stock. But if you aren't willing to buy on margin, "converts" have an advantage only when: (1) the bond yield is greater than the stock dividend; (2) prospects for the related stock promise to boost the market price of the convertible; and (3) the bond's investment value is so well secured that in a downswing it will usually hold up better than its related stock. If these conditions aren't fulfilled, you're better off buying either a straight bond or stock - depending on whether you want the safety of a bond or the growth potential of the stock.
Don't be misled by the idea that the bond aspect of a convertible keeps a floor under its price while the convertible feature allows a maximum ride with the stock. It isn't necessarily so. It's seldom possible to play it both ways. Usually you must give up some bond quality - or yield - in return for the conversion sweetener. Also, the more attractive the conversion terms and stock prospects, the more likely the convertible is to drop off in a market downswing. If you want price protection in a bearish market, you have to pick a convertible strictly on its merits as a bond, independent of any appealing conversion privilege.
To figure a convertible's value as a bond, check Moody's and Standard & Poor's "investment-value" ratings. These show the current price the bond would sell for without any conversion feature. As a rule of thumb, when a convertible is selling for more than 25% to 30% over this investment value, it ceases to have a bond's price protection - and is pretty much at the mercy of the stock market's gyrations.
The price of a convertible, of course, hinges on the price of the stock. For example, XYZ Corp. has a £1,000 convertible that provides for conversion to 100 shares of XYZ common - at £10 a share. When the stock goes to £12, the convertible price moves to £1,200 - in theory. But in practice, a convertible will often sell at a premium over its current conversion value - bid up either by bullish prospects for the stock or by margin buyers who can afford the premium on their low equity.
As for a bear market situation: generally, when stock prices are down, margin buyers get out - or stay out - of convertibles.
Fleeing From Common Stocks
It's no small wonder that as many people are still in the stock market as are. In the past five years--since the market bomb-out in 2009-70--many investors, weary of taking their temperatures every time they looked at the Big Board, have climbed into other frying pans. Some have been too hot in more ways than one!
Here is a review of a few of the entries made by people who are weary of the ways of common stocks in Wall Street:
In the world of bonds - the corporates run strong.
Yields in the corporate bond market have been so high lately that investors have been nailing down 8% returns by simply buying bonds of the Bell System. Some... see: Investments