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Coaches Corner
Financial

Need Growth, But Nervous About Risk? Consider Converting to Convertibles

by David N. Grenier

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Investors who lost much of their savings during the current bear market ironically need the growth that stocks can provide more than ever.

Depending on the size of their losses and how long they will have before they need access to their savings, many investors will either need to earn significant gains in coming years or scale back their financial goals.

Understandably, investors may not be emotionally prepared to invest more money into the market or even to stay in the market – especially since we’re in a global recession.  So what can they do to achieve growth without exposing their investments to excessive market risk?

Invest in convertible securities.  Convertible securities, which are typically issued as bonds or preferred stocks that can be converted into common stock, provide a stream of income, like a bond, but also have the potential for growth based on the option to convert into shares of the underlying stock.
Convertibles can provide the growth investors need, while potentially limiting losses and portfolio volatility.

Downside Protection, Positioned For Growth
Many investors have sought to reduce risk by selling stock holdings and increasing their cash positions.  However, cash will not help investors achieve their financial goals.

Why should convertibles be considered as an alternative to staying in cash or re-investing in stocks?  Because by investing in convertibles, investors can receive income, have downside protection and be positioned to realize growth when the market eventually recovers.  Investors who remain in cash run the risk of missing the turn in the market.

Convertibles are currently priced to provide attractive yields – double-digit yields, in some cases.  The income a convertible security produces adds to its total return, so if the price of the underlying stock falls, the income plus the bond features of the convertible security reduce the impact of the drop in stock price on the convertible security.  Companies having solid balance sheets with convertible securities maturing within the next three to five years (or that, alternatively, have issued the investor a three-to-five year “put” option) have very attractive downside protection qualities.

While investments in convertibles are still subject to credit risk, the same is true of an investment in a traditional stock or bond.  If a company goes out of business, investors will suffer whether they hold a company’s stock, bonds or convertible securities.

Combining the features of stocks and bonds is usually an advantage of convertibles, because when stocks underperform, bonds often remain more stable.  The current financial crisis, though, is unlike any experienced since The Great Depression and virtually every asset class has been affected, including both stocks and corporate bonds. At the end of March 2009, the S&P 500 equities index was down 11% for the year, but convertibles as a whole were up 2.8%, based on the Merrill Lynch U.S. All Convertible Index.

What other benefits do convertibles offer?
  • Lower volatility.  While every investment carries risk, convertible securities are less volatile than the underlying common stock they convert into.  And, by extension, a portfolio of convertible securities can be constructed to be less volatile than the overall equity market. The stock market is exceptionally volatile these days and is likely to remain so for the foreseeable future, given uncertainty over the President’s economic policies, the effectiveness of government bailouts, terrorism, consumer spending and other factors. Convertibles are less volatile than their underlying equities, because as the underlying stock declines, the convertible typically declines less and is generally supported by both its value as a fixed-income investment and its option value (i.e., the option to convert into common stock).
  • High current income.  In addition to the potential for growth, convertibles offer attractive yields – double digit yields in some cases.  Achieving both growth and income can add to total returns without adding risk.  In addition, the income a convertible produces provides downside protection, because it continues even if the price of the underlying stock drops.
  • Equity participation.  Owning convertibles in this market positions an investor’s portfolio to take advantage of growth when the equity market recovers and reduces investor anxiety about the timing of moving cash back into the equity market.
For investors whose portfolio is heavy with stocks, convertibles can add income and reduce portfolio volatility.  For investors whose portfolio is heavy with bonds, convertibles also provide income, but add exposure to growth to take advantage of the eventual market recovery.  And for investors who took their money out of the market, convertibles provide an appropriate strategy for re-entering the market without having to deal with the level of volatility inherent in the market.

A portfolio of convertibles can be appropriately diversified to complement an existing asset allocation strategy.  Convertibles are issued by companies in a broad mix of industry sectors with a wide range of credit quality.  Some have characteristics that make them behave more like stocks, as they have little downside protection but offer a significant opportunity for growth, and others have characteristics that make them more like bonds, as they offer significant downside protection, but less opportunity for growth.

These are uncertain times, no matter where you put your money.  But if you need both growth and stability – and who doesn’t – convertibles may be a great option.

About the Author:
David N. Grenier is president of Cutler Capital Management of Worcester, Mass. David has 17 years of banking experience, including 12 years at Fleet Boston Financial, serving most recently as Senior Vice President of the Fleet Private Clients Group and as Market Leader for the Worcester and Springfield, Mass. region. He led a team of investment and estate planning professionals that was responsible for managing $2 billion in assets for wealthy individuals and families, institutions and charitable organizations. He is a graduate of Amherst College. For more information, please visit www.cutlercapital.com or e-mail: dgrenier@cutlercapital.com.

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