What Should A Wary Investor Do

April 10, 2002
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GRAND RAPIDS — If the decline in the stock market and the Enron mess has left you skittish about investing, then you might want to think about buying a convertible. No, not a Miata or Mustang, mind you, but a securities fund.

Convertibles are hybrid securities, either interest-paying bonds or preferred nonvoting stock, that can be traded for common shares of the issuing company’s stock at a pre-set price — an option that could provide for some potential growth without the principle risk.

A convertible bond has a fixed maturity and pays a fixed coupon rate that is often higher than a firm’s dividend, but lower than its nonconvertible bond.

The stock version doesn’t have a maturity date and usually pays out a higher fixed dividend. Both can be converted into common stock and sold.

As a longer-term investment, convertibles have done better than high-yield corporate bonds and the Standard & Poor’s 500 Stock Index over the past three years. But within the last quarter, these securities haven’t kept pace with the S&P 500. (See related story.)

The Financial Planning Association of Michigan feels the convertible bond is a safer bet than the convertible preferred stock for the wariest of investors because bondholders have priority over stockholders should a company go bankrupt.

But according to the association’s Web site, planners who favor convertibles see either form of the security as more secure than stocks. Advocates claim that these securities can share in roughly 60 percent to 75 percent of a stock’s upside, with only 30 percent to 50 percent of the risk.

Merrill Lynch, which sells convertibles, reported that these tend to outperform common stocks in a falling market because the yields help cushion the effects of a decline.

In a rising market, the firm said that the securities provide an opportunity for capital growth, but tend to appreciate less than common stocks. In a stable market, Merrill Lynch felt convertibles offer a higher yield and the conversion gives the cautious a shot at an attractive total return.

The state chapter of the FPA noted, however, that not all financial planners were keen on convertibles. The chapter’s Web site held that “many like their diversification value because they are not strongly correlated to stocks,” a feature that might ease the nerves of an uneasy investor. The FPA advisory added that those who liked convertibles recommended a 5 to 10 percent portfolio allocation.

But don’t count local investment advisor Eric Ericksen among those who would suggest these securities to one of his clients, especially to one who is distrustful of the market.

“It’s speculative because you have to determine which companies are going to make it and turn around. But that’s not exactly a low-risk way to get into the stock market,” he said.

So why are such “speculative” securities making the rounds during a down market?

“When nobody wants to buy stocks, they have to sell something. What bad stock markets do is always create alternative bad investments,” said Ericksen. “Why convertibles are getting nice PR now is because the stock market is bad.”

Here is how a convertible works.

Say an investor buys a $1,000 bond from a firm and the conversion allows the buyer to pick up 50 shares of common stock at $20 a share. Later, the company’s common stock price reaches $60 a share. That guarded investor swaps the bond for 50 shares at $20 a pop and triples that investment.

But Ericksen pointed out a scenario like that one happens once in a while in a perfect world.

In many cases, however, he said convertibles have been offered by start-ups or high-risk, high-tech firms making these securities volatile — a situation that would likely send queasy investors running to their safety deposit boxes.

Another negative for Ericksen is that many convertibles are issued on bonds rated below investment grade. He added that stocks have done better over the past few months and the convertible interest rate is lower than what corporate bonds return.

“Wall Street calls convertibles the perfect investment vehicle because it has the illusion of safety and the chimera of future profits,” said Ericksen.

So if you’re a wary investor and are thinking about buying a convertible, Ericksen felt you should definitely talk to your financial planner — or better yet, to a car dealer.

“If you want income, you buy bonds. If you want growth, you buy stocks,” he said. “When you try to get both, you usually get neither.”

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