Chapter 9 - Share Privilege Securities-Convertible Bonds, Convertible Preferred And Warrants

So far we have gone into some detail about debt securities bonds and debentures and equities, namely, preferred and common stock. But the entire roster of marketable securities doesn't stop there. The imaginations of lawyers and financiers have dreamed up some hybrids that start out as one thing and may wind up as something else. These split-personality securities are called convertibles. The most common and popular variety is the convertible bond or debenture, so we'll talk about that first.

A convertible debenture has all the characteristics of any other long-term bond $1,000 denomination, a regular interest rate, a fixed maturity date, and semi-interest coupons. But it also has something else a conversion privilege. This merely means that the bond need not always remain a bond. It can be converted, if the holder so desires, into stock in the same company (sometimes into the stock of a subsidiary or affiliate company) under terms and conditions entirely spelled out in the indenture under which the bond was issued. If conversion is actually made, the bond disappears and the shares of stock issued instead replace the indebtedness on the corporate balance sheet. So, one virtue of the convertible bond from the company standpoint is already apparent it makes possible reduction of indebtedness and of interest charges the moment conversion takes place.

Rather than theorize, let's take a specific example.

Radio Corporation 3 % % Convertibles

Rather than theorize, let's take a specific example. Radio Corporation of America 3½'s, due 1980, were originally offered to stockholders at 102M in November, 1955. They were (and are) convertible into Radio common at 50 until maturity. That is, each $1,000 bond is convertible into 20 shares of common. In late 1956, Radio common sold as low as 34. Conversion value, quite obviously, was then unimportant as 20 shares of common had a total market value of $680, while the bond, valued mainly as an interest-bearing debenture, sold at around 92 ($920). Without any conversion privilege, the debenture might have sold a little lower, possibly around 88. In other words, investors were willing to pay $40 a bond for the privilege, extending to 1980, of converting the bond into 20 shares of Radio common.

By spring 1960, however, the whole picture had changed. Electronic shares were most popular, and Radio common sold not at 34 but at 75. So the "converts," instead of selling on the basis of the interest rate paid, sold on conversion value, namely, 152 ($1,520 for each $1,000 bond).

Buy Convertibles when Their Yield Is Highest

This shows you how convertibles work and gives you a clue to buying them. The trick is to buy them when they sell as closely as possible to the price they would command if they had no conversion privilege. That would have been, in the case of Radio 3½'s, 92 in 1956. Later on when the bond advanced, a new problem arose. Should the bond be sold at 152 and the profit taken, should it be held for a higher price, or should it be converted into the common? The answers depend on individual judgment and individual viewpoint. Many convertible bond buyers prefer to "stay" in "converts." Such people would be inclined to sell at 152 (or any other premium price they thought adequate) and to reinvest in another "convert" selling closer to an interest basis. In April of 1960, available and reasonable priced "converts" included Atlantic Refining 4½’s, @ 103M; Philips Petroleum 4¼'s, @ 107; J. I. Case Co. 5½'s, @ 92; and Cerro de Pasco Copper 5½’s, @ 1028.

It would serve no useful purpose to give here a long list of the available convertibles since their prices and conversion relationships change so rapidly that what is attractive today may be entirely out of a prudent buying range a month hence. But the logic behind convertible bonds should be perceived and understood. Convertibles, if bought properly, are one of the safest forms of speculation. The bond should defensively provide protection of principal value, certainly of interest return, and a high degree of marketability and collateral value. If the subject stock advances, there is the choice of cashing in on the profit or converting into the common (whose dividend income may exceed the coupon rate on the bond). Obviously, if you're going to buy a convertible bond, the stock into which it is convertible should be a lively or dynamic one and the company highly solvent. It would be silly to hope for a gain through a stock that gave meager promise of price advance. Buy "converts" in companies with a rising trend in earning power.

Some convertibles have rising rates of conversion specified. For example, the bond might be convertible at $50 for the first five years and at $60 for the next five. It is important, therefore, to know in detail the conversion terms and not allow, through carelessness, a conversion privilege to end without your taking action. Watch also to see if the convertible is called, in which case conversion may be compulsory.

The Convertible Preferred

The second convertible security, and a far less common one, is the convertible preferred. The principle is the same the ownership of a senior security with a stated or fixed rate of return (a rather narrowly fluctuating market) and convertible into common. If the common rises above the conversion rate, the preferred will of course advance. The convertible preferred will usually provide a higher yield than a debenture of comparable corporate quality, and it will fluctuate more widely.

Reasons for Purchase and Issuance of Convertibles

For investors, "converts" are attractive because of their dual quality defense in bear markets and built-in potential for gain in rising ones. For issuing corporations, convertability achieves two main purposes: (1) it enables the senior security to command a higher market price than would otherwise be the case; and (2) it is an indirect way of selling common stock at a higher price than the market would otherwise permit. In other words, "converts" reduce the cost of corporate financing. In special cases, too, convertibles make it possible to finance a new enterprise among institutional investors who would not be permitted to purchase promotional or non-dividend-paying stocks. For example, a gas pipeline may sell convertible debentures to an insurance company before the pipeline is even built.

Stock Warrants

There's another very popular security type, a close relative to convertible securities. It's called a warrant, and often comes into being because it's attached to a debenture as a sort of "sweetener." In some ways the warrant is the most baffling of securities. It has no book value, nor any share in assets, earnings, or dividends; neither does it have any claim or lien against the corporation. It is merely a written agreement or contract between the corporation and the holder permitting him to buy a share (sometimes more than one share, or a fractional share) at a certain price and for a certain period of time. A few warrants have no time limit and are called "perpetual." The principal virtue of the warrant is that it permits you to speculate in the stock of a given company with the least possible outlay of your own money. Yet the potential for gain is, in some instances, fantastic. Atlas Corporation warrants advanced, between 1942 and 1946, from 250 to $12.50. An original investment of $1,000 would have, in that short period, grown to $50,000.

In general, warrants will advance much faster than the subject stock; and the best time to buy warrants is when they have no real value at all. For example, on April 19, 1960, Kerr-McGee common stock sold at 49. There were (and are) outstanding warrants which expire June 30, 1964, entitling the holder to buy one share of Kerr-McGee Oil @ $80. Now this privilege, running for a little over four years, did not appear particularly alluring. The stock would have had to advance 31 points to give the warrant any real value. Yet these warrants sold on the same day (April 19, 1960) at 11¼, although to the untutored they might have seemed worthless.

There are essentially two kinds of warrants limited and perpetual. The limited ones require vigilance since, regardless of what you may have paid, a warrant held (and not exercised) after its maturity date is worthless. Of the limited variety, in addition to Kerr-McGee, Sheraton Corporation warrants might prove of interest. They give you the right to buy 1.2 shares of Sheraton Corporation common through September 1, 1966, at $20.83 a share. Again on April 19,1960, the stock sold at 17¼ while the warrant sold at 11. As a general rule, you should endeavor to buy the warrant at one-third the price of the stock. And watch out for an early maturity. Where possible, buy only the longest term warrant.

There are three well-known and actively traded "perpetual" warrants which you should follow if you're dabbling in this field: (1) Alleghany Corp. warrants, a perpetual call on the common @ $3.75; (2) Atlas Corp. warrants, a perpetual call at $6.25; and (3) Tri-Conti-nental warrants allowing you to buy 1.27 common shares forever at $17.76 per share.

There are actually several dozen actively traded warrants available, many of them relating to Canadian mining or industrial shares. If you are willing to take in stride the wide market swings which warrants can provide, then comb over the List carefully noting the ones you like and estimating as best you can a favorable buying range. Warrants are volatile securities that can make you a lot of money or lose your grubstake rapidly. So be as ready to sell as to buy lest your profits melt like butter in the noonday sun! Warrants are glamorous securities but only for the bold, the venturesome, and those who can make swift decisions.

Resume

1. Convertible bonds are ideal for conservative people who want to speculate a little.

2. Convertible bonds (and preferreds) are also useful for salting away profits.

3. When you buy "converts," buy good quality ones, paying as little premium as possible for the share privilege.

4. When your "converts" have advanced, decide promptly whether you're going to sell or convert.

5. Keep on the watch for expiration date of the conversion privilege.

6. Warrants are exciting speculations. They can multiply your dollars as well as your risks.

Are You Ready To Move Onto The Next Lesson? Click Here...