Investing in Convertible Securities

Why Invest In Convertible Securities

Convertible securities allow investors to participate in a company’s stock price appreciation while providing them some amount of downside protection against a decline in the underlying common stock’s share price. Consequently, convertibles offer investors a defensive way to invest in equities.

Most convertible bonds pay investors a fixed income stream that is greater than the yield on the underlying common shares, called “yield advantage.”

Convertibles are senior to common shares in a company’s capital structure, and convertible investors have unsecured claims on a company’s assets providing them a higher recovery value than common stock holders in a liquidation.

While past performance is no guarantee of future results, studies indicate historically that convertible securities have produced near-equity returns over the long term while assuming less risk, thus making them an effective product for portfolio diversification.

Convertible Securities Market

The most common convertible securities are convertible bonds and convertible preferred stocks. As of July 28, 2008, the size of the convertible market in dollar value was approximately $321 billion, with the following mix of convertible securities: 76.1% cash-pay bonds, 10.2% convertible preferreds (roughly $21.5 billion of this in financials), 7.2% mandatory convertible preferreds and 6.5% zero coupon based.

Convertible Securities Market

Source: Lehman, as of 12/31/07

Companies from all the major economic sectors have issued convertibles. They include such well-known, mature companies as Berkshire Hathaway, General Mills, Ford, and General Motors, as well as smaller, high-growth companies in sectors like healthcare and technology.

Investors in convertible securities include mutual funds, pension funds, convertible-dedicated funds, hedge funds and retail investors.

Coping with Increased Volatility

Market volatility has risen sharply since the summer of 2007, reaching levels not seen since 2003, according to the Chicago Board Options Exchange (CBOE) Volatility Index. Volatility is a normal part of the ebb and flow of market cycles, which means that finding securities with the potential to effectively weather market fluctuations is an important function of the asset-allocation process.

Since the summer of 2007, the average standard deviation (a measure of risk) of the convertible securities index was 12.6%, compared to 14.7% for the S&P 500. One reason for this performance advantage in recent years is that in falling stock markets, such as those in 2000-2003, the debt portion of the convertible security typically cushions the effects of a market decline.

Convertible Bonds 101

Convertible bonds are unsecured debt obligations of the issuer. They typically pay periodic – usually semi-annual – interest, and must be redeemed on their maturity date at face value for cash.

At maturity, convertibles are worth the greater of:

• Their redemption value – the value the issuer agrees to buy the bonds back, typically the par value, or
• Their conversion value – the issuer’s stock price multiplied by the bond’s conversion ratio.

Convertible bonds have an embedded option that provides the investor the right, but not the obligation, to exchange the bonds for a fixed number of the underlying common shares (or cash value of underlying shares). This structure offers the investor the prospect of participating in the upside potential of the issuer’s common stock.

Many convertibles have call or put provisions that investors should be aware of. Call options are advantageous to the bond issuers if the underlying common stock is trading above the convertible’s conversion price. This is because the issuer has the right to repurchase the bond from the holder at a specified price (usually par), thus forcing the holder to convert into common shares on the specified call date. In contrast, put options are advantageous to the bondholder if the underlying common stock is trading below the convertible’s conversion price. This is because the holder has the right to put (sell back) the bond to the issuer (usually at par) on the specified put date.

The S&P 500 is an unmanaged index of 500 widely held stocks. The Chicago Board Options Exchange’s Volatility Index is a key measure of market expectations of near-term volatility conveyed by stock index option prices.

Convertible Securities: Best of Both Worlds

Convertible bonds are generally divided into one of three categories: 1) hybrid/total-return investments, 2) high-yield/straight-debt alternative and 3) equity substitutes.

Convertibles that trade close to the conversion price are called hybrid/total-return investments and often exhibit all the qualities that make convertibles attractive. Although the trading range varies from security to security, these convertibles typically trade between 80% and 110% of par. When trading near their conversion price, they tend to benefit from price appreciation in the underlying common stock, while still enjoying some downside support provided by their fixed income components, benefiting from the “best of both worlds.” Convertibles trading in this range most effectively demonstrate the asymmetric return characteristics that make convertible securities an attractive asset class.

Convertible Price Behavior

A high-yield/straight-debt alternative can be characterized as a convertible containing a conversion option that is significantly “out-of-the-money” – that is, the price of the underlying stock is far below the conversion price. Because the option is not likely to be exercised, these securities generally trade similarly to regular bonds and are usually characterized by high yields and high conversion premiums. High-yield/straight-debt convertibles are typically sensitive to changes in interest rates and the issuer’s credit quality.*

In contrast, when the price of the stock underlying a convertible bond is significantly above the conversion price, the convertible is considered an equity substitute. These securities are generally characterized by low yields, low conversion premiums and a tendency to move in tandem with the underlying stock. Investors typically use equity substitutes to secure a higher yield than that provided by the common stock’s dividend. In addition, these securities offer stronger principal protection should the stock price fall significantly.

A common strategy involving convertibles trading in this range is to swap out of an equity that has had a significant run-up in value and into the associated convertible bond or preferred.

Potential Benefits

Convertible bond buyers usually invest in these securities in the hope of obtaining one or more of the following benefits:

• Upside participation should the stock price increase,
• Downside protection should the stock price decrease,
• Typically higher current income than that represented by dividends issued to owners of the underlying company’s common stock,
• Less volatility than common stock, and
• A claim on the issuer’s assets senior to that of the holders of the common stock in the event that the company files for bankruptcy.

* Because the high yields available from these securities are generally a function of their below-investment-grade quality, Raymond James typically does not focus on this type of bond.

Diversification

Convertible securities traditionally have had a low correlation with fixed income securities and high, but imperfect, correlation with equities. Consequently, convertibles are frequently used to diversify a portfolio. During the 10 years ending December 2007, convertibles were negatively correlated with the Lehman Aggregate Bond Index (-0.05), and demonstrated a somewhat high, but not perfect, correlation (0.74) with the S&P 500.

As the table below indicates, convertibles often tend to move with the equity markets and have little correlation to bonds.

10-Year Correlation Analysis

Source: Bloomberg, December 31, 2007. Equities are represented by the S&P 500 Index, an index of large-cap stocks; convertible securities are represented by the Merrill Lynch All U.S. Convertibles Index, an index of domestic corporate convertible bonds and preferreds; corporate bonds are represented by the Lehman Brothers Aggregate Bond Index, an index of investment-grade or better fixed-rate debt securities, including government, corporate, asset-backed and mortgage-backed securities with maturities of at least one year. Performance data represents past performance and does not guarantee future results.

Convertibles have actually outperformed the S&P 500 on average over the last 10 years. In the 10 years ending December 2007, convertibles produced an average annual return of 7.23% – as measured by the Merrill Lynch All Convertible Securities Index – outpacing the 5.91% return for the Standard & Poor’s 500 stock index.

Annualized Returns

Sources: Bloomberg, Reuters; 1/1/1997-12/31/2007.

¹Merrill Lynch All Convertible Bond Index.

²S&P 500 Index.

³Lehman Brothers Aggregate Bond Index, an index of investment-grade or better fixed-rate debt securities, including government, corporate, asset-backed and mortgage-backed securities with maturities of at least one year. Past performance offers no guarantee of future results. This hypothetical example is for illustrative purposes only and is not intended to imply or represent a specific return on any particular investment. It does not reflect fees or expenses that would reduce the total return. Investors cannot invest directly in an index.

On a trailing 10-year basis ending December 31, 2007, convertibles have outperformed equities on a risk-adjusted basis. A common method of measuring risk-adjusted returns is the Sharpe Ratio, which expresses the excess return per unit of risk. As depicted in the following chart, convertibles have had a Sharpe Ratio that has been higher (favorable) than equities over the 10-year period.

10-Year Analysis

Source: Bloomberg, December 31, 2007. Equities are represented by the S&P 500 Index, an index of large-cap stocks; convertible securities are represented by the Merrill Lynch All U.S. Convertibles Index, an index of domestic corporate convertible bonds and preferreds; corporate bonds are represented by the Lehman Brothers Aggregate Bond Index, an index of investment-grade or better fixed-rate debt securities, including government, corporate, asset-backed and mortgage-backed securities with maturities of at least one year. Performance data represents past performance and does not guarantee future results. This hypothetical example is for illustrative purposes only and is not intended to imply or represent a specific return on any particular investment. It does not reflect fees or expenses that would reduce the total return. Investors cannot invest directly in an index.

Historical Returns

Source: Bloomberg, December 31, 2007. Equities are represented by the S&P 500 Index. Convertible securities are represented by the Merrill Lynch All U.S. Convertibles Index, an index of domestic corporate convertible bonds and preferreds. Bonds are represented by the Lehman Brothers Aggregate Bond Index, an index of investment-grade or better fixed rate debt securities, including government, corporate, asset-backed and mortgage-backed securities with maturities of at least one year. Performance data represents past performance and offers no guarantee of future results.

Portfolio Examples

Investors allocating a portion of their equity positions to convertible securities may be able to achieve the returns they need to meet long-term goals while assuming less risk. For those investors more heavily weighted in fixed income, convertible securities can add a growth component to the portfolio, while still providing fixed cash flows.

The following hypothetical investments illustrate that adding convertible securities to a portfolio not only adds diversification, but also potentially lowers risk exposure while delivering comparable performance returns.

Source: MPI Stylus

Large-Cap Core Stocks are represented by the S&P 500 Index. Bonds are represented by the Lehman Brothers Aggregate Bond Index. Convertible Securities are represented by the Merrill Lynch All U.S. Convertibles Index. Results assume reinvestment of all capital gain and dividend distributions. An investment cannot be made directly into an index.

Reprinted with permission of MainStay Investments and MacKay Shields LLC, ©2007.

Investor A has a portfolio consisting of 100% large-cap core stocks.

Investor B diversified holdings into large-cap core stocks and bonds. Although the 15-year return was slightly lower than Investor A, the portfolio risk level was significantly lower at 8.72%.

Investor C is the most diversified among all the hypothetical investors. As illustrated in the chart above, taking a 20% allocation from equities and investing in convertible securities can deliver comparable returns with slightly less risk.

This hypothetical example is for illustrative purposes only and is not intended to imply or represent a specific return on any particular investment. It also does not reflect fees or expenses which would reduce the total return. Past performance is not indicative of future results.

Source: MPI Stylus.Bonds are represented by the Lehman Brothers Aggregate Bond Index. Convertible securities are represented by theMerrill Lynch All U.S. Convertibles Index. Results assume reinvestment of all capital gain and dividend distributions.An investment cannot be made directly into an index.

Reprinted with permission of MainStay Investments and MacKay Shields LLC, ©2007.

Investor A has a portfolio consisting of 100% bonds.

Investor B has a portfolio consisting of both bonds (90%) and convertible securities (10%). Over the 15-year period, this portfolio generated a slightly higher return than Investor A’s portfolio, and with slightly less risk.

Investor C has a portfolio consisting of a lower allocation to bonds (85%) and a higher allocation in convertible securities (15%). Over the 15-year period, the portfolio generated a higher return than those for Investors A and B, while taking on about the same amount of risk than Investor B and less risk than Investor A.

Convertible debentures:

• Can be used to achieve more favorable risk-adjusted portfolio returns,
• Historically demonstrated returns similar to common stocks with less volatility,
• Typically generate a higher current income relative to the issuer’s common stock dividend yield,
• Offer investors more protection in the event of the underlying company’s insolvency than that available to common and preferred stockholders, and
• Are attractive to both fixed income and equity investors.

This hypothetical example is for illustrative purposes only and is not intended to imply or represent a specific return on any particular investment. It also does not reflect fees or expenses which would reduce the total return. Past performance is not indicative of future results.

Convertible Bond Terms

Mandatory Convertibles

Mandatory convertibles are convertible bonds that have a required conversion or redemption feature. Either on or before a contractual conversion date, the holder must convert the mandatory convertible into the underlying common stock. These securities provide investors higher yields to compensate holders for the mandatory conversion structure. In contrast, cash-pay bonds, like conventional non-convertible fixed income, pay interest on a periodic, usually semiannual basis. Mandatory convertibles offer higher equity participation and less downside protection than convertible bonds/convertible preferreds.

Zero-Coupon Convertibles

A zero-coupon bond is a corporate fixed income security that does not make regular interest payments and that can be converted into that corporation’s common stock. Because zero-coupon bond prices tend to move with the stock prices of the issuing company, zero-coupon convertibles tend to offer lower yields than regular zero-coupon bonds. Although the lower yield deters some investors from these bonds, zero-coupon convertibles offer the potential to benefit from higher stock prices and thus for greater capital gains.

Busted Convertibles

A busted convertible is one that trades well below its conversion value. The result is that the security is valued as regular debt because very little chance exists that it will reach the convertible price before maturity. Busted convertibles typically trade at prices and yields very close to other non-convertible debt.

Conversion Ratio

The number of shares of stock for which the convertible can be exchanged.

Conversion Value

The value of the convertible if converted into the common (i.e., the price of the stock multiplied by the conversion ratio). This value is often referred to as parity.

Conversion Price

The dollar value at which a convertible security can be converted into common stock. This price is established at the time of issue. In practice, exercising the conversion option prior to the maturity (or call date) is rare.

Premium

The percentage by which the price of the convertible exceeds the conversion value.

Coupon

The yearly interest paid on a bond. Bonds are typically issued with a par value of $1,000, the price at which they will be redeemed at maturity.

Par

The face value of the bond instrument.

Current Yield

The annual rate of return based on the current market price, calculated as the stated dividend or coupon divided by the price paid for the security.

Yield Advantage

The current yield in excess of the dividend yield of the underlying common stock.

Call Price

The price at which the issuer may call a convertible that has a call feature.

Hard Call Protection

Most convertibles have a period of time at which the issue cannot be called for any reason. This is referred to as “hard call” protection.

Provisional Call Protection

A convertible that has provisional call protection can be called only if the underlying stock rises to a pre-determined price and remains at that price, or higher, for a set number of days. This is also referred to as soft call protection.

Call Option

An embedded option that grants the bond issuer the right to repurchase the bond from the bondholder at a specified price (usually par) on a specified call date. This feature is to the issuer’s benefit and it is typically used to compel the holder to convert the security into common stock.

Put Option

An embedded option that grants the bondholder the right, but not the obligation, to put (sell back) the bond to the issuer. This is to the benefit of the bondholder.

Correlation

Correlation is a statistical measure of how two securities move in relation to each other. Correlation is computed into what is known as the correlation coefficient, which ranges between -1 and +1.

Perfect positive correlation (+1) implies that as one security moves, either up or down, the other security will move with it. Alternatively, perfect negative correlation (-1) means that if one security moves in either direction, a security that is perfectly negatively correlated will move by an equal amount in the opposite direction. If the correlation is 0, the movements of the securities are said to have no correlation; their performance relative to each other is completely random.

Sharpe Ratio

A measure of risk-adjusted performance. It is calculated using standard deviation and excess return over a risk-free rate to determine reward per unit of risk.

Investment Risks

Market Risk

The prospect that the price of the convertible will decline if market conditions (such as interest rates, credit quality, liquidity or the value of the underlying common stock) change.

Reinvestment Risk

The possibility that coupon payments will be reinvested at a lower rate.

Call Risk

The possibility that the issuer will call the convertible prior to maturity and/or at a price less than the purchase price.

Liquidity Risk

The possibility that selling the convertible at an acceptable price and when desired may not be possible because of inadequate demand.

Dividend Risk

The prospect that the underlying company increases its common stock dividend and that the convertible debenture’s current yield does not rise to match it. This may reduce or even negate the yield advantage over the common stock. Most convertibles are issued with provisions that require the company to adjust the conversion ratio to compensate convertible holders should the dividend increase.

Takeover Risk

The possibility that the issuer will be acquired, which may change the conversion terms and options. This can also result in a change in the issuer’s financial makeup.

Default Risk

The prospect that the issuer will become insolvent and unable to repay bondholders their principal at maturity and/or continue to make periodic coupon payments.

Currency Risk

The risk that changes in exchange rates will affect the convertible security.

Taxation

Convertibles carry with them a wide range of income tax implications regarding coupon, principal accretion and conversion that can vary by structure and issue. In some cases, investors may be taxed for a larger portion of income than they actually receive, resulting in reduced cash flow.

Why Raymond James

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This tradition of excellence and caring goes beyond providing you investment expertise. Your Raymond James financial advisor will work closely with you, listening to your needs and giving you information specific to your financial goals – before you even invest.

We encourage you to learn more about investing and the economic developments that affect your money. All of us at Raymond James are devoted to serving your needs effectively, efficiently and completely.

Want to Learn More?

For more information about convertible debt securities – or other investments that may be able to help you diversify your portfolio, please contact your Raymond James advisor, or call Brian Heck at 727-567-2455.

This material is intended to provide a basic understanding of convertible securities, but should not be considered a comprehensive resource. Investors should read the applicable prospectus prior to investing in convertible securities.

Investors are urged to seek tax advice based on their particular circumstances from an independent tax professional.

There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices generally rise. Investing involves risk and investors may incur a profit or a loss. Diversification does not ensure a profit or protect against a loss.

High-yield (below investment grade) bonds are not suitable for all investors. When appropriate, these bonds should only comprise a modest portion of your portfolio. Swapping out of an equity into another security may result in a taxable event.

Preferred securities are considered fixed income investments as their income payments are fixed over the term of the investment and will react similarly to other debt investments to changes in the market conditions.

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