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Note: This article is part of a series I contributed to on strategies individual investors can use to manage risk while still capturing solid returns. Part I is here, and Part II is linked to below.

Last time, we discussed how investors willing to analyze opportunities up and down a company's capital structure open up numerous possibilities to generate absolute returns - in particular, through looking for undervalued embedded options in convertible securities. Reading the last article will be helpful to understanding this one, but an abridged summary is that convertible securities offer superior coupon/dividend payment security, while offering upside through a call option allowing the holder to convert their security into a specified number of shares of common stock.

As an example, consider the Bank of America 7.25% Non-Cumulative Convertible Preferred Stock, ticker BAC-L (your online broker or financial website may have its own way of entering preferred stock tickers – such as BAC.L on TradeKing, or BAC.PL on Yahoo Finance). Breaking that down, each share has a par value of $1,000 and pays annual distributions totaling $72.50/share in equal quarterly installments; the caveat is that because this is a non-cumulative security, if Bank of America (NYSE:BAC) misses a dividend payment, preferred stock holders see no income for that period and cannot recover the amount at a later date. Companies – especially ones with the stature of Bank of America – do not take the decision to skip a dividend payment lightly, and for that to happen to the preferred stock would mean that common stockholders would see no dividends either. Nonetheless, in these extraordinary financial times anything should be considered in the realm of possibility.

Below is a chart of the year-to-date performance of the convertible preferred, relative to Bank of America common stock:

click to enlarge

As for conversion rights, the holder is allowed to convert their holding into 20 shares of Bank of America common stock at any time. Since BAC recently closed at $14.50, the current conversion value equals

(20 * $14.50 = $290)

which will fluctuate along with the value of the common stock. Now, the convertible preferred stock trades around $641, so how do we determine if this is a good value?

Like most financial valuations, this requires some working assumptions. Let's start by thinking of this as a call option. The difference between the current price of the convertible and the current conversion value is

($641 - $290 = $351)

which is similar to a call premium, because the intrinsic value of this option is $290, and the price in excess of that represents the remaining time value of the option. That works out to almost $17.50/call for the option premium, and that might strike you as pricey without even knowing the theory behind valuing a perpetual call option. You'd be correct, as the two options pricing models used offered values between $3.00 and $3.60 per call.

But there is one important difference between a traditional call option and one embedded in convertible preferred stock: the former offers no cash flow in the meanwhile, whereas the latter does – in this case, an 11.3% yield. What is the value of the preferred stock itself?

Since the quarterly distributions are set, the challenge here is ascertaining an approximate discount rate to capture the risk of financials. The yields on Bank of America trust preferreds (a type of subordinated debt mainly used by financial companies) run around 9.5%, and using the capital asset pricing model for BAC common stock suggests 14.5% is a very rough cost of equity estimate. Thinking back to the earlier lesson on capital structure, preferred stock is between subordinated debt and common stock, so the discount rate for that can be assumed to be somewhere in between those two figures – just over 12% is what we'll use. That 12% discount rate yields a value for the preferred of $630.

Now, we need to sum everything up – the $630 value of the preferred, along with an option value in the range of $60 to $70, suggests the total package is worth just under $700. Just before publication, the last quote on BAC-L was $647, so this could be slightly undervalued – but many assumptions were made, and fine-tuning inputs could easily wipe out the difference between current price and initial value estimate. Although this specific convertible might not be the best value, looking through the universe will give investors a chance to find high yields and underpriced call options – in many cases, the perfect combination to create absolute returns, regardless of what the market does.

Disclosure: no positions

Source: Is Convertible Stock the Smartest Way to Own Bank of America?