John Calamos was basically the father of convertible bond investing. He applied option pricing models and mathematical formulas way before they were in vogue. He has written two books on convertible bonds. On April 27 Calamos, of Calamos Asset Management (Nasdaq:CLMS), moderated a panel discussion entitled "Convertible Securities in Today's Market" at the Milken Institute Global Conference. Milken is probably the best conference in the country - jam-packed with politicians, Fortune 500 CEOs and investors. The panel also included Jason Lee of Goldman Sachs (NYSE:GS), Michael O'Grady of Merrill Lynch and Michael Rosen of Angeles Investment Advisors.

Historically Speaking
A convertible bond is like a bond in that it pays a coupon. However, it has upside potential in that it has a strike price that can be exercised should the stock rise in value. Historically, convertibles have had more upside than downside and have done well in volatile markets. Over the past 10 years, the average convertible has appreciated at about 5%, according to Calamos' analysts. That beats the heck out of a negative return for the S&P 500. Convertibles have also done this with 30% to 40% less volatility as measured by standard deviation. Thus far for 2009, convertibles have posted positive returns. (For further reading, see Convertible Bonds: An Introduction.)

IN PICTURES: Eight Ways To Survive A Market Downturn

Issuers Find Convertibles Less Restrictive
Companies like issuing convertibles because the debt load is less onerous. Some issuers include Amgen (Nasdaq:AMGN), Home Depot (NYSE:HD), Transocean (NYSE:RIG) and Johnson & Johnson (NYSE:JNJ). Usually the convertibles are less restrictive and favor issuers. Convertible yields generally offer a few points less than comparable straight bonds. Of course, interest is tax deductible. Calamos predicted there will be more public offerings because $25 billion worth are being redeemed this year.

In the heydays of the stock market (which ended last year), hedge funds would participate in trades called convertible arbitrage. This involved buying the underlying convertible bond and shorting the equity. As Calamos pointed out, this wasn't good enough. Hedge fund managers wanted more than the 6% opportunity that this yielded. With leverage one could reap much higher returns; with greater risk, of course. (For more, see Trading The Odds With Arbitrage.)

Incidentally, Calamos' stock has been hammered. Its 52-week high was $24, and its low was $2.55. The company has seen its assets under management drop precipitously. As of April 30, the price had climbed back up to $11.43.

How Do Convertibles Fare During Bankruptcy?
During the Q&A, I asked how convertible holders fared during bankruptcy. The answer is that it depends on the class of convertibles. Some are senior and some are preferred. The more senior and the better the assets, the better the convertible will be.

Bottom Line
In my opinion, a convertible will only do as well as its underlying company in a tough economy. In most bankruptcies, convertible holders will get little. If you plan to buy convertibles, look for industries like energy and healthcare that will do well in the future.

For more, see Introduction To Convertible Preferred Shares and Why Companies Issue Convertible Bonds.

Related Articles
  1. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  2. Investing News

    Ferrari’s IPO: Ready to Roll or Poor Timing?

    Will Ferrari's shares move fast off the line only to sputter later?
  3. Professionals

    Top 5 Highest Paid Hedge Fund Managers

    Understand what a hedge fund is and why hedge fund managers make so much money. Learn about the top 5 highest paid hedge fund managers.
  4. Investing Basics

    6 Reasons Hedge Funds Underperform

    Understand the hedge fund industry and why it has grown exponentially since 1995. Learn about the top six reasons why the industry underperforms.
  5. Stock Analysis

    5 Cheap Dividend Stocks for a Bear Market

    Here are five stocks that pay safe dividends and should be at least somewhat resilient to a bear market.
  6. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  7. Fundamental Analysis

    Use Options Data To Predict Stock Market Direction

    Options market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
  8. Professionals

    How Brokers are Candy-Coating Alternatives

    Alternatives have become a sexy choice for many advisors. But they also come with additional risks that are not always clearly spelled out to clients.
  9. Stock Analysis

    2 Oil Stocks to Buy Right Now (PSX,TSO)

    Can these two oil stocks buck the trend?
  10. Investing News

    What Alcoa’s (AA) Breakup Means for Investors

    Alcoa plans to split into two companies. Is this a bullish catalyst for investors?
  1. Who do hedge funds lend money to?

    Many traditional lenders and banks are failing to provide loans. In their absence, hedge funds have begun to fill the gap. ... Read Full Answer >>
  2. What licenses does a hedge fund manager need to have?

    A hedge fund manager does not necessarily need any specific license to operate a fund, but depending on the type of investments ... Read Full Answer >>
  3. What do hedge fund analysts do?

    A hedge fund analyst primarily provides support to a portfolio manager on how to best structure the hedge fund's investment ... Read Full Answer >>
  4. Can mutual funds invest in hedge funds?

    Mutual funds are legally allowed to invest in hedge funds. However, hedge funds and mutual funds have striking differences ... Read Full Answer >>
  5. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  6. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!