Getting Four Times the 10-year Treasury Yield from Convertibles

To close out the second quarter of 2019, I want to examine the convertible securities sector for a couple of reasons.

First, the fact that market conditions now favor this asset class means that convertible securities deserve our attention. Second, interest rates are trending lower since stocks are trading higher.

These two catalysts are not only what convertible securities thrive on, but they are also primarily why I want some exposure to the sector for the subscribers of my Cash Machine advisory service.

THE STORY ON CONVERTIBLE SECURITIES

Right now, I want to start by focusing on convertibles, how they work and how they can be a vital part of generating cash flow for one’s portfolio. It is important for high-yield income investors to understand where this asset class fits into our high-yield approach. As the market is affected by the forces of interest rates, inflation, rising and falling gross domestic product (GDP) rates and volatile energy prices, it just makes sense to be flexible and be willing to move into the right asset classes when the investing landscape characteristics change.

Convertible securities include convertible bonds and convertible preferred stocks.

A convertible bond is a fixed-income debt security that yields interest payments but can also be converted into a predetermined number of common stock or equity shares by an investor. On their own, such pure convertible securities serve as a low-paying class of income securities that would normally not fit our Cash Machine profile. If you do not already know, our objective is capturing big dividends first and then shooting for capital gains.

The way in which we can exploit this sector and still maintain a high-dividend yield is to put a slice of our capital into closed-end funds that combine convertible securities with high-yield bonds and some leverage to capture an 8% to 10% yield, while taking full advantage of the stock market’s upside. This also is the clearest explanation of why we want to own this variety of asset.

A simple reason for owning these securities is that a convertible bond can be converted into a company’s common stock at a given strike price. That means an investor can exchange the bond for a predetermined number of shares. The conversion ratio can vary from bond to bond, but you’ll find the terms of the convertible (such as the exact number of shares or the method of determining how many shares the bond is converted into) in the bond’s indenture. For example, a conversion ratio of 40-to-1 means that every bond (with a $1,000 par value) you hold can be exchanged for 40 shares of stock.

Convertible bonds typically pay 2% to 4% yields and they also usually offer a lower yield than regular bonds, since there is an option to convert the shares into common stock and collect the capital gain. However, should the company go bankrupt, convertibles are ranked just below the company’s senior bond holders, so you have a better chance of getting some of your money back than the people who are holding common stock.

A convertible preferred stock (sometimes just called convertible preferreds) also has features like a convertible bond. However, convertible preferred stock is subordinated to the convertible bond debt of the issuing company. A convertible preferred typically offers a coupon of 3% to 6%. Such a convertible preferred normally will pay a cash coupon on a quarterly basis and is also perpetual or has a long maturity of usually 25 years.

The order in which a company prioritizes debt responsibility is as follows: senior corporate bondholders get paid first, junior bond holders get paid second, preferred bond holders get paid third, preferred shareholders get paid fourth and the common shareholders get paid last.

OBJECTIVES AND RISKS OF CONVERTIBLE SECURITIES

Convertibles are an excellent choice for investors who are looking for capital appreciation, but who also want to protect their original investment in a bond equivalent. As noted, aside from leveraged exchange-traded funds (ETFs), convertibles provide some income on their own, but it’s not very high. It is as if investors give up a higher return on the bond in exchange for the option to convert into shares at a later date.

One risk associated with convertibles is that most are “callable.” In other words, the company can force convertible bondholders to convert the bonds to common stock by calling the bonds — referred to as a “forced conversion.” When investing in convertibles, remember that the convertible securities are only as good as the underlying stock. If the convertible offers a high premium, be very wary.

If the company’s stock declines to a price that makes the convertible feature of the bond worthless (as long as the company is solvent), the bond will trade based on its yield just like any other bond. There is a price level to which a bond will drop and then the bond’s price will go no lower as long as the company can pay its interest and the principal upon maturity.

PARITY AND SENIOR CONVERTIBLES

If a $1,000 convertible bond is convertible into 50 shares of stock, the parity price of the stock is $20. If the price of the stock moves up to $25, then for the stock and bonds to remain at parity, the bonds would have to be trading at $1,250. A convertible bond provides the performance attributes of both a common stock and a bond.

The upside of the convertible bond comes from its common stock component. Meanwhile, the downside protection comes from the cash coupon, fixed maturity and the fact that its status in the capital structure makes it “senior” to common and preferred stock (meaning that a preferred bond has a priority for payment when a company is liquidated). The bottom line here is that convertible bonds are paid before the preferred and common stock dividends.

Companies generally issue convertible securities for working capital. Those that have access to conventional means of raising capital (such as public offerings and bank financings) might offer convertible securities for particular business reasons. Companies that may be unable to tap into conventional sources of funding sometimes offer convertible securities so that they can raise money more quickly.

Companies can offer lower-yielding coupon rates when issuing convertible securities than if they were issuing high-yielding bonds because of the allure of capital gains. This is especially true when interest rates are high and companies need to raise fresh capital.

In financing conventional convertible securities, the conversion formula is usually based on a fixed price. The convertible security financing arrangements also might include caps or other provisions to limit dilution when holders of convertible securities convert them into common stock. Just be sure you fully understand the terms of the convertible security financing arrangement, including both the circumstances of its issuance and how the conversion formula works.

HOW TO BUY AND SELL CONVERTIBLES

The most common method for buying convertible securities is to use either a full-service or discount brokerage. The minimum investment for a convertible is typically $1,000 — the price of one bond. Convertible preferred stocks trade on the stock market like regular shares, so the prices usually range from $25 to around $100.

I like the convertible securities market because it addresses the desires of both bond and equity investors. For equity-oriented investors, convertibles can be viewed as a stock with a put option. The upside of the convertible comes from the underlying stock. The higher the price of the underlying stock goes, the higher the convertible price should go.

The downside protection of the convertible comes from its higher-yield, fixed-maturity value and status in the capital structure. All of these factors combine to give the security downside protection.

A convertible also can be viewed as a bond plus a call option. In this case, the upside of the convertible comes from the call represented by the conversion feature. Moreover, the downside protection also comes from the bond attributes of the security, including the generally higher-yield, fixed-maturity value and place in the capital structure.

Either way, we have an asset class that has been designed to pay out a handsome dividend yield. It also remains a relatively safe investment vehicle that offers excellent upside potential. Within the Cash Machine portfolio, I recommend the AllianzGl Diversified Income & Convertible Fund (ACV), which sports a current yield of 8.8% and pays a monthly income of $0.167 per share. That’s four times the 2.2% yield that the 10-year Treasury Note is paying.

Shares of ACV are up 28.6% for 2019, way higher than the 15.16% for the S&P 500 or the 17.50% for the Nasdaq. Top holdings in ACV include convertible debt in Wells Fargo, Microchip, Crown Castle, Liberty Media and Bank of America.

High-yield assets like ACV, among others, fashion the blended 9.0% yield in the Cash Machine portfolio and its 21 positions. If outsized income and yield is a high priority, then look no further than Cash Machine. Click here to learn about what it can do for you. Give your portfolio a raise in the second half of 2019 that will make a real difference.

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