Convertible Bonds: Cashing In on Desperation

This level of undervaluation represents what we believe is a very rare opportunity—one we have never witnessed in more than 30 years of managing convertible portfolios.

That’s what Nick Calamos recently said about convertible bonds.

And who better to know we’re looking at “a very rare opportunity” in convertible bonds?

Calamos is Co-Chief Investment Officer of Calamos Investments which manages about $23.8 billion in assets with a big chunk of them in convertible bonds. The New York Times calls Calamos “one of the most sought-after fund managers in the country…after developing an expertise in convertible bonds.” He clearly knows what he’s talking about when it comes to convertibles - little-known, exotic securities which offer high levels of current income like bonds but offer all the capital appreciation of stocks.

The Financial Times sums the current opportunity up best:

Viewed as an asset class halfway between an equity and a bond on the risk scale, convertible bonds are now considered to be undervalued by many investors.

Best of Both Worlds

Convertibles offer investors a lot. A convertible is usually a bond or preferred share which is “convertible” into shares of common stock. For instance, if you bought a convertible bond, you would receive all the interest, get everything normally accorded to bondholders, but you would also participate in any rise in the value of the company’s stock. If the shares rise above a predetermined point, you convert the bond into the shares and take the profit. If they don’t you just take the interest and wait for the bond to mature.

It’s the elusive win/win for investors. Convertibles are the closest thing to a perfect investment I’ve ever found and we’ve been covering them here in the Prosperity Dispatch for a long time.

I’m not alone here though. The right unique features of convertibles attracts some of the biggest and smartest money on the planet. Warren Buffett, sovereign wealth funds, and dozens of others all are buying up convertibles right now. Here’s why.

Thanks in large part to the financial crisis and overwhelming aversion to take on any risk at all, convertibles are cheaper than they’ve been in decades (see chart below from October’s Calamos Market Outlook (pdf file)).

click to enlarge

In Great Company

The inability and unwillingness of banks to lend has created many great opportunities for those of us with some investment capital. Companies are hard desperate for cash and they’re willing to offer convertible securities to anyone with capital.

Leading the way in the race to accumulate convertibles has been Warren Buffett’s Berkshire Hathaway (NYSE:BRK.A). Amidst the panic a few months ago, Buffett was offered a deal to good to refuse when Goldman Sachs (NYSE:GS) offered up $5 billion worth of preferred shares which yield 10%. If you recall, Goldman also issued warrants, which gives Buffett the option to buy Goldman shares at a predetermined price. The combination of warrants and preferred shares gave Buffett a “synthetic” convertible investment in Goldman, as Berkshire gets the 10% dividend and will go along for the ride if Goldman’s share value recovers.

Buffett has been making some smaller moves as well which haven’t generated quite as much publicity. For instance, the leading U.S. gypsum board (a.k.a. drywall) maker, USG Corp (NYSE:USG) has had a tough year. With the construction market grinding to a halt USG sales have been in sharp decline and it’s share price has fallen from a high of more than $100 to less than $10 today.

A few weeks ago, we learned how desperate USG really has become. The company needed a $400 million cash infusion just to survive. Berkshire Hathaway was there with $300 million to help out. Of course, Berkshire received $300 million worth of convertible preferred shares paying a 10% annual interest. Prem Watsa of Fairfax Financial (NYSE:FFH) - one of the other gurus we keep a close eye on – was there with the other $100 million. Once again, those with the capital and a nose for a good deal are getting their terms - and their terms include a convertible feature.

It’s not just the smart money betting big on convertibles though. The big money is right there too.

The Financial Times reported the following:

Pension funds and sovereign wealth funds are starting to invest large amounts in convertible bonds after forced selling by hedge funds pushed prices to all-time lows…European pension funds and Middle Eastern sovereign wealth funds to invest heavily – with one planning to put $1bn into the market.

True Desperation

The credit crisis has made companies downright desperate for cash. However, it’s not just high-risk ventures like small technology companies, which have to offer convertible securities to attract new capital, many big, safe names have to do it too. For instance, Nomura Holdings, Japan’s largest brokerage announced it is raising $4.3 billion through a convertible debt offering. Orix (NYSE:IX), a $5 billion Japanese financial services firm, said it’s raising $1.5 billion by selling convertible bonds.

Once a darling of the oil boom, Oilexco (OILXF.PK) has watched its share price plummet 95% from its recent highs because it can’t get the cash it needs. It attempted to raise C$150 million from a convertible bond issue and was willing to pay a 15% interest rate on top of it. To date, it hasn’t found any takers for such a sweet, one-sided deal.

Clearly, times are getting tough out there, and these are just a few examples. If you look at the biotech and alternative energy industries, there are dozens more that are also desperate for cash. These are the times when you get the best return for taking on risk, because the world has become very risk averse. While the flight to safety has pushed up the value of safe assets (i.e. government bonds are at multi-decade highs), it has also put those willing to take on risk right now in a very good position.

The truly rich take risks….smart risks. Right now is the time to start taking on some of those risks. Convertible bonds, which offer current income like bonds and all the upside of stocks, is looking like one of those smart risks to take right now.

Disclosure: None

Comments

[Larry House:]

They may look like a smart risk, but they aren't. There is absolutely no hurry to get into convertibles or other high yield bonds. They carry way too much risk for the reward as show in the current yields. Convertibles will be fine WHEN recovery is in sight; we aren't there yet and may not be for several quarters. Don't let the high yields suck you in. This is the time for higher quality bonds; the time for higher risk will come, but it is way too soon.

2008 Dec 22 11:49 AM

[Crashnburn:]

I did very well with CHI until I sold all of my holding of it in Oct. 2007. Since then, the share price has declined 45%. I hadn't even considered buying back into CHI until I read this article. I'm going to put it on my watch list, but for now, I'm 84% in TIP, and 16% cash. I'm thinking 5% of CHI will bring my targeted bond exposure to 20%.

Also, as of yesterday, Morningstar says CHI has a 4.5% premium. I have a hard time paying a significant premium for anyfund. It looks too much like a sales charge (I know it isn'!).

2008 Dec 22 07:14 PM

[bsharvy:]

Are there any ETFs?

2008 Dec 30 08:08 AM