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Berko: Convertible bonds can be a smart step

By Malcolm Berko

Published: August 10, 2018, 6:01am

Dear Mr. Berko: Please explain convertible bonds. We’re in our late 50s. We are not aggressive investors and own a $310,000 portfolio of stocks — mostly utilities and other income stocks — yielding 3 to 9 percent. A stockbroker tried to explain convertible bonds to us, but she just made it more confusing. Could you give us a simple explanation so we can have a clearer understanding? And could you recommend some convertible mutual funds to buy? We have about $21,000 to invest.

— PB, Waterloo, Iowa

Dear PB: Convertible bond investments can be made to appear as complicated as differential equations or as simple as Simon. Sadly, the supposed experts enjoy complicating this subject by using recursive brute force and dynamic programming algorithms to explain how to choose attractive convertible bonds. So I’ll just give you the Reader’s Digest version.

It can be said of convertible bonds that they capture the best of both worlds. They have the safety and income of a plain vanilla corporate bond plus the upside potential of a common stock. Just like regular bonds, CBs are fixed-income investments and pay interest to investors twice a year. But unlike the case with regular bonds, as the underlying stock price increases, so does the market value of the CB. And unlike regular bonds, a CB gives an investor the option to convert his bond into common stock. Unlike common stock, a CB is not worthless if a company declares bankruptcy. CBs can only fall so far because all bonds have prior claims on assets. Another reason is that a CB has a maturity date, at which time the company is obligated to return the par value to each CB holder.

Here’s how it buries. Assume that Associated Bagel & Matzo issues a convertible bond at $1,000 with interest at 5 percent and that it will mature in November 2038. Then assume that the indenture on the ABM bond declares that the bond can be converted into 25 shares of common stock, which doesn’t pay a dividend, any time between now and maturity in 2038. The conversion and break-even price ($1,000 divided by 25) is $40 a share.

Assume you’ve owned a 5 percent $1,000 ABM CB for five years. Because it pays $50 interest annually, you’ve earned $250. Now assume that scientists have discovered that matzo and bagels cure cancer. Resultantly, ABM stock zooms above the $40 conversion price to $75, and the CB, because it converts to 25 shares, zooms to $1,875. Now you have various options.

1. You could tell the broker to convert your bond into 25 shares of stock worth $1,875. There would be no charge for the conversion, though some cheapskate brokerages might demand a conversion fee of $50 to $150. And though you’d have a gain of $875 on your $1,000 ABM CB, there would be no tax on this conversion until you sold the stock.

2. Rather than convert, you could sell the ABM CB at $1,875 and make an $875 profit.

3. You could continue holding the CB to maturity, knowing it pays $50 interest annually because the stock pays no dividend. Some professionals believe that CBs give good balance and diversity to a long-term growth portfolio. There would be comfort in knowing that each time ABM stock rises $1, the CB would increase by $25. However, on the flip side, each $1 decline in ABM stock would reduce the CB’s value by $25.

I’d recommend the following exchange-traded funds: The SPDR Bloomberg Barclays Convertible Securities ETF (CWB-$53.78) has $4.7 billion in assets, and the dividend yields 3.9 percent. The iShares Convertible Bond ETF (ICVT-$59.15) has $200 million in assets, and the dividend yields 2.2 percent. And the First Trust SSI Strategic Convertible Securities ETF (FCVT-$30.40) has $161 million in assets and a 2.2 percent dividend. Or you could invest in individual convertibles by Wells Fargo, Intel, Bank of America and Herbalife.

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