The Convertible Investing Guide

To the average investor, bonds are a safe and unexciting asset. You hold them in your portfolio, collect interest and get your money back at maturity. They’re a good foundational asset… but not great if you want your investments to pay off anytime soon.

But there’s more to these assets than meets the eye. In fact, convertibles – also called convertible notes or convertible bonds – are actually one of the most powerful tools on the market for solving the catch-22 investors find themselves in right now…

Between high inflation and a volatile market, we’re left with two choices: risk our money in the stock market or hold on to our cash as inflation eats away at its value by the day.

But Wall Street has been taking advantage of convertibles to bank double-digit gains (or higher) from many of the highest-growth companies in the market for decades. It’s one of Wall Street’s best-kept secrets, and it’d rather you not find out.

Convertibles are a special type of bond, and they work in much the same way as regular bonds. You’re still effectively loaning your money to a bond issuer, often to be paid back with interest. (If they do not pay interest, they are usually available at a discount.)

However, the  yields on convertibles are usually a little lower than normal… but the gains can be far bigger.

That’s because a convertible bond can be converted into a predetermined number of shares of the underlying company’s common stock or equity shares. You can do this at certain times during a bond’s life – depending on the details of the contract – and it’s usually at your discretion as the bondholder. And some convertible bonds are callable, meaning the issuer can “call” them back and pay you par value ($1,000 per bond).

As I said above, convertibles are one of Wall Street’s best-kept secrets. Mutual funds, institutional investors and other major players in the stock market use them all the time to take home colossal, safe returns. But I’m willing to bet you’ve never heard of them until now. Simply put, the people taking advantage of convertibles don’t want you doing the same. So convertibles don’t get a whole lot of press…

Despite the fact that you may not be familiar with them, convertibles are actually one of the oldest assets on the market. They date back to the late 19th century, when a man named James Hill purchased the St. Paul and Pacific Railroad.

At the time, the Industrial Revolution was well underway. North America was booming and needed basic infrastructure. So Hill saw an opportunity in the market and decided to build a railway to the West – through the Rocky Mountains.

That had never been done before… and his plan required new tracks through hostile wilderness and new terrain. Many of his peers thought he was crazy. They even called this project “Hill’s Folly.”

So as you can imagine, getting money to build this railroad was difficult. Investors simply didn’t want to take the risk.

But James Hill was smart…

He created an entirely new security to ensure he got his funding: convertible bonds. He essentially said, “If you invest in my company, I’ll give you three things.”

1. I’ll GUARANTEE your money. No matter what happens, your principal will be safe, backed by contract.
2. I’ll PAY you interest for investing. You’ll get regular income, quarter after quarter.
3. I’ll give you huge UPSIDE. As the value of our company goes higher, so will your investment.

Investors jumped on the deal, and they reaped the rewards.

Hill finished his Great Northern Railway to Seattle in 1893. And investors saw significant returns on their investments as the company expanded across the American Northwest and facilitated much of the region’s economic growth.

In fact, the original route is still used today, and it was all possible because of the convertible note that James Hill created.

It lets you invest in many of the highest-growth companies in the world – with a fraction of the risk.

No matter what happens in the markets, with convertibles, your principal is protected. Plus, they even give you steady, reliable income. Now, let’s get into exactly what they are and how they work…

The Best of Both Worlds

The biggest advantage of convertibles is that you combine the safety of bonds with the growth potential of stocks.

As with ordinary bonds, you’re still contractually guaranteed to get the face value of the bond back (with interest) at maturity. Face value is usually $1,000. You also get some additional security, considering how bondholders are treated during bankruptcy relative to shareholders…

In bankruptcy court, bondholders always get paid first, so even if the bond issuer goes bankrupt, bondholders are in line to get paid ahead of shareholders, meaning they will usually get some of their investment back. Shareholders often get nothing and lose their investments completely.

But convertibles also have some of the growth potential of stocks. See, if the share price of the bond issuer’s stock grows, you can convert the bond to shares. You can then sell the shares and take home a profit.

A convertible has something called a conversion price. That is the share price at which a convertible bond can be converted into shares. It’s set when the bond is issued based on the conversion ratio – the number of shares you can convert a single bond into.

To arrive at the conversion price, you simply divide $1,000 by the conversion ratio. So if a bond’s conversion ratio was 20 – meaning you’d get 20 shares of stock if you converted – the conversion price would be $50 ($1,000 divided by 20 equals $50).

You would convert your bonds to stock only if the stock was trading above $50 (because if it was trading at $50, it’d be worth the same as the face value you’d get with the bond). If the stock was trading at $50 or below, you’d simply hold the bond and receive $1,000 at maturity. If the stock was trading at, say, $100, you could convert the bond to stock at $50 per share and own 20 shares of stock, worth $100 per share, or $2,000 total (compared with the face value of $1,000). You could then sell the shares, hold them, sell some, etc.

Now, with ordinary bonds, the price will fluctuate slightly over time, but it’s rarely as dramatic as what shares of stock will do. That’s because a bond has little to do with the stock of its issuer. It has more to do with the issuer’s credit rating and debt load.

Convertibles, on the other hand, are directly tied to the share price of their issuer’s stock. As a result, convertibles go up or down in price along with the price of the underlying company’s stock. In that way, they function similarly to a call option. The higher the underlying shares go, especially when they exceed the convertible price, the higher the price of the convertible bond will likely go.

However, you can’t lose your initial investment if the play goes against you as you can with an option. With a convertible, if you choose not to convert to stock, you will still get the $1,000 face value of the bond back at maturity, plus any interest you made while holding the convertible.

Ultimately, you get a hybrid asset with the stability and safety of a bond but the growth potential of a stock that works a bit like a call option.

So how does a convertible work?

Convertibles in Action

Let’s say Company X, which is trading for $8 per share, has issued a convertible bond at par value of $1,000. It has a conversion price of $10 (that is, the price at which you can convert the bond to stock) and a coupon of 3%. It matures in five years and has a convertible ratio (the number of shares for which you can convert one bond) of 100. At that ratio, $1,000 could buy 125 shares of the company on the open market or one convertible bond.

If you buy the bond, there are two scenarios that can play out from there.

Scenario No. 1

You just hold the bond to maturity…

You collect 3% interest annually for each of those five years, getting $30 per year, or $150 over the life of the bond. And at maturity, you’ll get the $1,000 face value back.

Scenario No. 2

You convert the bond to shares if the stock spikes in value…

Let’s say that over those five years, you’ve collected $150 in interest, and then Company X’s share price really takes off.

Over a few months, we see Company X’s stock rise to $20 per share. So you trade in your bond for 100 shares of Company X stock at $20, worth $2,000 (compared with the $1,000 par value you’d receive at maturity if you’d held the bond). You can sell the shares immediately and pocket $2,000.

Now, you’ve already doubled your initial investment, but you also get to keep the $150 in interest you made, for a total of $2,150, or a return of 115%.

Spread out over the five years you held the bond, it’s as if you held a stock that appreciated 23% every single year – all while keeping your principal protected.

Had Company X shares fallen to $1, you wouldn’t have converted to shares and instead would have gotten your $1,000 back at maturity. But someone who had bought $1,000 worth of stock would have been out most of their investment.

And it’s really as simple as that. You either protect your money with a bond that will give you interest over its life or convert the bond to shares if the price takes off (and then take home a massive windfall).

Again, it’s almost like a very secure call option play that you really can’t lose…

So how do I pick the best convertible bonds to present to you?

Systematic GAINs

Now, while you’re fairly well protected if a bond issuer’s business is weak, we want to avoid the bad bonds and locate only the best of the best to maximize our returns.

And I use a simple system to weed out the mediocre opportunities from the great ones. I came up with an acronym so it’s easy to understand.

GAIN.

It stands for growth, advantage, income and no-risk.

Let’s take a look at each factor individually, starting with the most important of the lot: growth.

Simply put, when a company sees big revenue growth, its stock price generally rises as a result. So I look for companies that are experiencing double-digit revenue growth for multiple quarters in a row.

That tells me the company is on a revenue tear and its share price is almost certain to see colossal growth in the near future.

That first step alone eliminates about 50% of all 8,000 stocks on the market.

But to go along with that, I want to see operating cash flow growth of at least 20%. But hopefully much higher. That means there aren’t any tricks or accounting gimmicks going on.

If cash flow is growing along with revenue, it means the business is working… and working well.

Revenue and cash flow growth together is step one.

Step two is advantage, meaning a business’s ability to protect its long-term profits and market share from competing firms.

I want to see that the company issuing the convertible has a durable competitive advantage. It should have a strong brand identity that’s globally recognized, a loyal customer base, patents to protect its intellectual property or lower costs relative to its competitors.

Ideally, it’ll have all of those, among other competitive advantages. Regardless of what its advantages look like, any company I recommend will have a considerable edge over its competitors in one or more ways.

The third step, income, has to do with the bond itself.

The best thing about convertibles is that many of them give you two ways to generate income.

The first way is through capital appreciation. If you convert that bond into shares and sell, you can make a big profit.

The second is through the yield, or the interest you’re paid for holding the bond. In that way, convertibles work exactly like conventional bonds. It’s a win-win.

Now, if a bond doesn’t pay a high yield outright, it may still have a great yield to maturity. The yield to maturity is similar to the total return earned by an investor who buys a bond at market price and holds to maturity.

If you buy a bond lower than its face value ($1,000), not only is your yield effectively higher (because the coupon is based on the $1,000 face value, not whatever price you buy the bond for), but you will still receive the $1,000 face value at maturity regardless of what you paid.

For example, say you bought Company Y’s 5% coupon bond that matures in three years for $900 as opposed to $1,000. (Bond prices can fluctuate significantly over time, so that wouldn’t be uncommon.)

At maturity, you would collect $150 from the coupon payments and receive the $1,000, effectively adding $100 to your return on that bond. So your yield to maturity would be 8.87%, almost double the 5% yield the bond had at issue.

I look at the yield and yield to maturity of each bond I recommend and screen for the ones that will give you the best payments for holding them.

Finally, there’s step four: no-risk.

Now, no investment is 100% no-risk. But your only real risk with convertibles is the company going out of business, which is unlikely. So convertibles are already 99% no-risk.

One of the main ratios I look at to determine a company’s financial health is its debt-to-equity ratio. It’s a measure of how much debt a company is carrying in relation to the value of its assets.

A company with a debt-to-equity ratio ABOVE 1.0 means it has more debt than assets… so it’s higher risk.

A company with a debt-to-equity ratio BELOW 1.0 means it has more assets than debt… so it’s lower risk.

So for every company I choose, I want to make sure it isn’t overleveraged (meaning it has a lower debt-to-equity ratio).

To summarize, I want to invest in a company with high growth and a big competitive advantage. And it should pay substantial income and offer little to no risk.

If you buy a convertible bond issued by a company like that, you’re giving yourself huge upside with very little risk.

And with my GAIN system, I will be targeting opportunities that could fly to 1,100%, 1,500% and even 1,800% or more…

Who? What? When? Where? Why? And How?

Now, let’s cover why convertibles are such a well-kept secret on Wall Street. Simply put, most brokers won’t play ball with everyday investors.

You won’t find convertible bonds listed with the vast majority of big online brokers. And many full-service brokers will flat-out tell you no if you ask to buy a convertible bond through them.

I’ve reached out to contacts I’ve made in my decades in the market. I spoke with some of the largest firms on Wall Street. And most wouldn’t even discuss convertibles with me.

But not all of them…

I have identified a handful of brokers who are willing to help Main Street investors. I receive no compensation from any of them.

You can set up an account with any of them, but you will also have to set up an account with a full-service broker. There may be account minimums as well.

To set up an account with any of these brokers, you will need to contact them directly. They aren’t like Fidelity or Charles Schwab, where you can apply for an account entirely online. These brokers provide personal service and offer you far more than the run-of-the-mill online broker.

Call around and see which one works best for you…

Andrew Brookman from Alpha Strategic Advisors

900 Pacific Street
Stamford, CT 06902
Phone: 203.524.0711
Fax: 203.429.9311
Abrookman@alphastrategicadvisor.com
www.alphastrategicadvisor.com

Martin Truax and Josh Newman from The Investment Planning & Management Group of Raymond James

1100 Abernathy Road NE
Building 500, Suite 1850
Atlanta, GA 30328
Phone: 770.673.2177
Toll-free: 866.813.9911
Fax: 770.673.2150
Josh.Newman@RaymondJames.com
www.ipmgatlanta.com

Ron Chandler from Summit Investment Management

5005 W. Loomis Road
Suite 200
Milwaukee, WI 53220
Phone: 414.291.4488
Toll-free: 800.518.0945
Rchandler@suminvest.com
www.suminvest.com

You can get a more detailed look at each of these brokers on the Oxford Club site here.

Finally, there are three brokers Oxford Bond Advantage has worked with for years.

• Ron Kramer, B. Riley Financial: 917.887.2386, 877.70.BONDS (877.702.6637) or RKramer@BRileyWealth.com
• Ron McCoy, Freedom Capital Advisors: 407.614.2006, 877.79.MCCOY (877.796.2269) or Ron@FreedomCapitalAdvisors.com
• George Walters, International Assets Advisory: 321.293.0284 or GWalters@IAAC.com

Any one of these brokers will be able to help you buy convertible bonds. You can try your luck at one of the big online brokers, but even if you call their bond desks and ask personally, your odds of success are slim. The online brokers can often handle your regular bond trades, but not convertibles.

Regardless, once you’re set up with a broker who will let you trade convertible bonds, it will be a matter of calling them and giving them the details and quantity of the bond that you’d like to buy. Your broker will do the rest and get the bond for you.

A Better Way to Invest

Convertibles are the best solution for the modern investor sandwiched between a volatile stock market and high inflation.

They represent a way to invest in fast-growing companies and capture stocklike gains with a fraction of the risk. They’re a fantastic solution for many people out there looking to get ahead in a market and an economy that are working against many investors.

And with this guide in hand, you’re set to take advantage of each and every convertible bond I recommend with my GAIN system.

For a long time, Wall Street has been enjoying an asset with the growth of a stock and the safety of a bond. And now Main Street can as well.

Good investing.