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.
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.)
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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.
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.