Buying Convertible Bonds with Alan Muschott CFAMarch 3rd, 2013 by Marc Prosser
Alan Muschott, CFA has been the portfolio manager of the Franklin Convertible Securities Fund since 2002. Convertible securities are bonds or preferred stock that can, under certain conditions, be converted into common stock. While it’s not a 100% technically correct definition, a convertible can be thought of as a corporate bond combined with a call option to buy common stock.
In the United States, there are about 500 companies which have convertible bonds. Outstanding convertible bonds have a market value of around $200 billion. To put this in context, convertible bonds represent less than 10% of the entire US corporate bond market. Investing in convertible bonds is a specialty.
The Franklin Convertible Securities Fund has annual rate of return of 8.98% during the last 10 years. Learn Bond’s interviewed Alan Muschott about why his fund has done well, and about convertible bonds as an asset class.
Learn Bonds: How do convertible bonds compare to the US stock market?
Alan Muschott: The bonds in our fund generally have about 75% of the upside of the issuer’s common stock, and about 50% of the downside. However, we don’t invest in busted convertibles or in-the-money convertibles. A busted convertible is one where there is a very low probability of it converting into stock. The prices on these convertibles trade in line with corporate bond market. On the other hand, convertibles where the option to convert is worth more than the value of the bond tend to have price moves that directly correlate with the stock. Only about 40% of convertible securities have the risk/reward characteristics we want.
LB: Is your investing style different than other convertible bond funds?
Alan Muschott: Yes. There are many funds which take a view on which way the stock market is heading. When they think the stock market is going to rally they load up on in–the-money convertibles. When they think the stock market is heading down they load up on busted convertibles. Effectively, they seek to time the market. We believe that clients that invest in a convertible fund want the unique characteristics of a convertible. So we strive, through all market cycles, to identify for “balanced” convertible securities that we believe offer an attractive risk/reward profile.
LB: Instead of investing in a convertible, why not just buy a bond and an option for a particular security?
Alan Muschott: There are two reasons. The first is that the type of options to purchase stocks that are embedded in most convertibles are for long periods of time. Let’s say 3 to 7 years is typical. Options of this length are generally not available for sale on the market. Secondarily, convertibles are generally priced based on the issuer acting logically and “forcing” a conversion at the first opportunity. However, we have found that many issuers don’t do this, and let the option stay active for much longer periods than necessary. In many instances, when an investor buys a convertible they are getting a longer option than the price suggests.
LB: How do calls for convertible bonds work? Are they like high-yield bonds, where the maturity of the bond is 8 years and it’s callable after 4?
Alan Muschott: First of all, convertible bonds are highly varied in terms of maturity, credit grade and call features. When a corporation calls a convertible, not only are they returning funds to the bondholder, but they are also eliminating the option to buy the stock. If the option is in the money, then bondholders are effectively being forced to convert into stock or give up profits on the investment. Typically, convertible bonds have three stages: hard call protection, soft call protection, and no call protection. In the first stage which may last 3 or 4 years, the bond cannot be called. During the next stage, the bond can be called but only at a price which is a premium to the bond’s principal. And finally, during the no call protection stage, the corporation can call the bond at any time, and bondholders must then choose to convert or be paid the principal amount.
LB: Have companies stopped issuing convertibles with interest rates being so low?
Alan Muschott: There was a shortage of new issues up until about 4 months ago. However, the shortage was not just the result of low interest rates, but low stock prices. Many companies don’t want to issue convertibles when they think that their stock price is very undervalued.
LB: Do you have anything to add?
Alan Muschott: Many people want to know how rising inflation and interest rates will affect convertibles. As a large portion of a convertible’s price is based on the embedded option, the impact of rising interest rates on a convertible is lower than a non-convertible bond with similar characteristics. Inflation, while bad for bonds, is not necessarily bad for stocks.