Convertible Bond Funds:
Problems and Prospects for the Hybrid Bond Market

by
Katalin Szolga ^©

Submitted to the Committee on Undergraduate Honors at Baruch College of the City University of New York in partial fulfillment of the requirements for the degree of Business Administration in Finance and Investments with Honors.

December 2000

TABLE OF CONTENTS

CHAPTER ONE
INTRODUCTION

"Hedge funds crowd the convertible-bond market, long-term buyers look for alternatives." (Ablan, 2 000: C 16).

"Zero interest: investors balk at some convertibles' prices." (McGee, 2000:C1).

"Convertible sector breaks 1999 issuance record via $500 million deal from telecom firm Covad." (Ablan, Vames, & Calamba, 2000: C20).

1.1 Background of the Problem

Over the last decade, the news reports from the financial papers have documented the changing attitudes of many investors toward the bond market. Along with changing perspectives on the safety of investing in equity stocks have come some changes in corporate views on financing debt, protecting what has been gained, and planning for future security with safer alternatives to stocks. Companies are also beginning to look for options going beyond preferred stocks to secure their investments and assets. Meanwhile, portfolio diversification and risk reduction have become the paramount concerns of investors who were risk aggressive and confident only a few months ago. The alternative financial instruments available today include bank certificates of deposit, zero-coupon bonds, short to medium-term government bonds, mutual and indexed funds, top-rated corporate bonds, and the subject of this study: convertible bonds.

The purpose of this study is to analyze convertible bond funds, their performance and potential, as viable alternatives to equity stocks, mutual stock funds and conventional bond investments. Convertible bond funds are one option now available in the financial markets, to aid smaller investors in achieving maximum input with minimum restrictions, and to achieve specific financing needs of issuers. The paper will also consider firms' fiscal objectives in issuing such bonds; the primary objective of any company, of course, is to safeguard earnings and assets, and maximize growth potential with new capital. Although it is not the only bond option, the convertible bond will be shown to be among of the more desirable.

Today, there are many investment alternatives, which are somewhat "off-the-beaten-path" from the conventional portfolio strategy (Fraser, 1997:152). Derivative instruments and funds of all kinds are appearing; among these, one of the less known investment options is a convertible bond fund. Convertible bonds consist of fixed income securities, bonds or preferred stocks, which can be exchanged, or converted, at any time (during the life of the bond) for a specific number of shares of the company's common stock. This conversion is done at the option of the holder, and under certain specified terms and conditions (Block and Hirt, 1989: Chpt. 19).

Convertible bonds are thus "option" securities which make it possible for small companies, private start-ups, large companies and corporations, to sell debt, or preferred stock, that could not otherwise be sold easily, or which would be very costly to the issuer. Larger companies typically use warrants and convertibles to lower initial costs of selling securities, and to lock in new common stock future sales. Conversion of a bond or preferred stock does not always generate significant additional funds for the company, but it can lower the company's overall debt ratio (Bringham and Gapenski, 1991: Chpt. 18).

The return to more stable bond and bond fund portfolios is a welcome trend to many investors. The overvalued high-tech and dot.com stocks of recent months have seen their share prices deflating at a breathtaking pace. Most market observers agree that a bear market is emerging for tech equities, and share values for most equities around the world stock exchanges reflect a growing pessimism. Internationally, companies are using convertible bonds as a safeguard option, or as one observer put it, "a safe haven in a falling market." ("It's a Stock for the Ups, a Bond for the Oops," 2000:70).

The primary research question I addressed in this paper is therefore: "Are convertible bonds necessarily the best alternative to conventional stocks and bonds under present market conditions?" Related study questions, acknowledging the volatility of the equity markets today, include: "How long will this alternative still be preferable?" "Are convertible bond funds a secure long-term hedge?" and last but not least, "What can we expect, or predict, about the economy and inflation that will have bearing on investment decisions in the future?"

These questions evolve from the particular nature of the financial instrument. Convertible bonds are hybrid securities, which can act either as stocks or as bonds, depending on the value of the underlying common equity. They combine benefits of both stocks and bonds, while protecting the company from some of the risks of a volatile stock market. Convertibles pay an income as regular bonds do, and they provide growth potential since they can also be redeemed for shares of common stock in high-growth times. Convertible bonds may be purchased individually or mutually through a convertible bond fund (Fraser, 1997:152).

To quickly answer the first question: even if convertible bonds are not necessarily the best option, the basic potential advantages and disadvantages of convertible bonds should still be profiled. The two primary advantages that convertibles have over stocks for their holders are 1) the higher yield offered, and 2) the senior claim on company assets. For its part, the company or corporation can sell the stock at a higher than market price. The convertible may also be the only means of gaining access to the capital market for some firms.

The critical advantage to the holder is the convertibles' senior claim on assets. The holder has a clear right to a fixed semiannual coupon and a prior claim on assets, coming ahead of shareholders' claim in a bankruptcy (Gorham, "Chicken Little Stocks..." 1999:200). When the underlying common stock rises, however, the convertibles' fixed-income characteristics are less important and they begin to trade more like a stock. The return on the convertible bonds in this case is much less impressive (Gorham, "Rag-Top Bonds," 2000:270). These same strengths and weaknesses hold true, obviously, for convertible bond "mutual funds" made up entirely of this class of investment paper.

Surprisingly, there are complexities involved in evaluating bonds. One consideration is that a convertible is just one security among a variety of instruments available for raising capital. Warrants are another issued security companies can use to generate cash. Warrants are bought at a stated share price and generate needed equity capital when exercised. Their value is speculative and dependent on market movement of stocks, however. The holder of warrants will earn a capital gain only if the stock price rises. Conversely, convertible bonds provide holders with a chance for capital gains in exchange for a lower coupon rate, and the issuing firm gets the advantage of that low coupon rate. These tradeoffs are inherent in these types of speculative investment decisions, of course (Bringham and Gepenski, 1991:611).

1.2 Convertible Bond Funds and the Growing Market for Derivatives

Convertible bonds are a special class of derivatives, or financial instruments whose values are based on other, underlying assets or index values. Derivatives are a broad group of secondary financial instruments; a group, which by 2000 has expanded into an estimated total of US $81.5 trillion in notional value in the world market (McCarthy, 2000:35). At the same time, derivative instruments such as convertible bonds are as old as paper money itself, which originated as an exchange medium for more substantial, tangible assets such as gold, silver or grain. The most basic definition of a financial derivative, according to the Economist (1996: S6), is "a financial contract the value of which is derived from the value of another underlying asset, such as an equity, bond or commodity." Pricing that asset or contract can often involve complex, fast changing financial calculations familiar only to industry specialists and traders. Convertible bonds are therefore subject to this same acceleration of volatility, but retain some stability through their conversion to straight equity. Thus, DV bonds combine aspects of stocks, bonds and complex derivatives.

1.3 Risk Factors of Commodities Convertibles

Convertible bonds and convertible bond funds are not inherently safe or unsafe. Until the early 1990s, precious metals investments were particularly promising and performed well. Despite the disinflationary environment at that time, gold and silver had 75-percent gains. Investing in gold or silver generally meant forgoing income and waiting for positive price movement. In June 1993, however, Battle Mountain Gold issued two million shares of convertible stock at $50 each. Each share had an 83.25 dividend convertible into 4.762 shares of common stock. The company projected that it would produce 400,000-plus ounces of gold in 1993, and upwards to 600,000 by 1998 from properties it owned in the US, Australia and Bolivia. Although the convertible was at 61, yielding 5.3 percent by September 1993, the changes in the gold price dictated the convertible's movement rather than interest rates.

Commodities of all kinds are volatile. The nation's second largest food processor, Conagra, yielded 5.6 percent on its 81.6875 convertible preferred E (30), which converted into 1.018 common shares. The Midwest floods hampered the company's Agri-Products formula feed, fertilizer and agricultural chemical business as well as its milling in 1993. Currently Conagra's earnings growth and dividend growth are successful due in part to its processed food division. Commodities are prone to seasonal swings (Stovall, 1993:87).

Some management teams find ways to create their own investment problems. In the airline industry, airline common shares are risky investments. In a price war environment, unoccupied airline seats result in operating losses. Two airlines that have a history of eventual recovery from convertible preferred issues selling down in price, along with the underlying common, are Delta and USAir. Delta Airlines' convertible preferred C is influenced more by changes in interest rates than by the common price, or at least until the common stock strengthens considerably. This is partly due to the challenging acquisition of Pan-Am's routes integrated into Delta's operating environment USAir on the other hand survives from cash infusions from British Air (Stovall, 1993:87).

Despite their complexity and lack of transparency, convertible bonds and other derivative funds have grown in recent years because of their flexible basis of value and their many risk hedging effects. In recent years, derivatives have developed into complex exchanges combining forward contracts, convertible bonds, stock options, loan swaps, and credit obligations of many kinds. So while it is wrong to speak of derivatives as a single group with a common risk/reward ratio or factors, we can think of them as a diverse class of complex financial instruments, increasingly removed from the familiar equities, stock options and futures of the stock exchanges. Derivatives are, in fact, the principle new units of exchange for corporations, traders, merchant bankers and bond houses in fast-growing global electronic financial networks.

There are a number of ways to classify and analyze financial derivatives such as convertible bonds. However, some of the basic divisions include those that are exchange-traded and those that are traded over the counter, those that are based on tangible assets such as common shares or currencies, and those based on less tangible arrangements such as warrants or swaps (agreements to exchange income streams for some future period). Finally, those that are used for insurance or hedging (the predominant type today) and those used for purely speculation. In the end, of course, any asset can be subject to speculation, which is always seen in relation to risk and reward.

A derivative contract or instrument can have many different valuation methods, since the number of possible combinations of assets and time-based contracts is theoretically infinite. But like all assets, derivatives are ultimately valued in relation to risk and return. The most commonly accepted asset valuation method is 'net present discounted value," the projected interest or return value over time for any instrument or asset. As the Financial Accounting Standards Board defines this measure,

In general, the fair value of any financial instrument is equal to the present value of its expected future cash flows, discounted by an appropriate rate of return that compensates investors for bearing risk. The key valuation technique is the following discounted cash flow (or present value) model:

Where: CFt is the expected cash flow for period t and r is the discount rate, used to present value the cash flows. We will be applying variations of this formula in subsequent valuation calculations. (FASB 2000)

This universal formula for valuation is applicable to any financial instrument regarding its rate of return over a time period. The value of a convertible bond (before conversion) is derived from cash flows composed of periodic interest payments and a principal payment at maturity. The present value price of a bond is specifically expressed in the following formula:

Where: Pb = the market price of the bond
It = the periodic interest payments
Pn = the principal payment at maturity
T = the period from I to n
n = the total number of periods
Y the yield to maturity (requested rate of return)

To calculate the price of a bond, the Present Value Tables may be used. The annuity is comprised of the stream of periodic interest payments. The present value of the stream of interest payments may be computed by multiplying the periodic interest payment by the present value of an annuity interest factor as follows:

A = R X If pwa (n,I)

Where: A = present value of a stream of n interest payments
R = periodic interest payment (same as It above)
i = the market required rate of return

By applying the present value of a $1 formula, the present value of the principal payment may be computed as follows:

P = S X Ifpw (n, i)

Where: P = present value of principal payment
A = the principal payment at the end of the nth period
i = the market required rate of return (yield to maturity)

The price of the bond will be the sum of the present value of the interest payments plus the present value of the principal. (Block & Hirt, 1989:Chpt. 19).

There are three factors, which influence an investor's rate of return on a bond:

1. The rate of return demanded for giving up current use of funds on a non-inflation-adjusted basis, known as the required real rate of return,
2. A premium to compensate the investor for the effect of inflation on the value of the dollar, known as the inflation premium and
3. All financial decisions made within a risk-return framework or the risk premium. Primary interest risks in determining the yield to maturity are those of business and of financial. Bond prices are inversely related to the yield to maturity (Block & Hirt, 1989:Chpt. 19).

But as we will see, it is not always so easy to accurately value complex derivatives, which are often contingent upon contract terms (option rights, strike rates, etc) as well as future events (equity prices, interest rates and so on). The terms for convertible bonds can be complex, and these issues are multiplied with regard to convertible bond funds, so the best place to begin is probably by reviewing basic principles.

1.4 Definitions of Key Terms

Before proceeding with the discussion of the advantages and disadvantages of various types of bonds and other derivatives, it will be useful to present a short list of some basic definitions commonly used in financial markets. The following list of key terms illustrates some of the major features and the underlying factors involved in convertible bonds:

Beta: A measure of the sensitivity of an asset's return to changes in the value of the market portfolio, which is also a measure of the asset's marginal contribution to the risk of the market portfolio.

Convertible Bond: A bond, which can be converted to shares or cash at a prearranged, fixed rate.

Default Risk: The most basic level of firm-specific risk associated with a financial instrument.

Cross-hedging: Contract where the derivative and the hedged item are referenced to indexes whose changes are imperfectly correlated.

Delta: The sensitivity of the price of the convertible to the changes in its common value (Stovall, 1993:87).

Duration: Time measure of the price sensitivity of a fixed-income security to changes in interest rates.

Financial Futures Contract: A futures contract in which the standardized commodity is a particular type of financial instrument.

Forward Transaction: An exchange rate transaction that involves the exchange of bank deposits denominated in different currencies at some specified future date (Mishkin, 1995).

Forward Contract: A private contract between two parties, similar to a futures contract (see below) but not exchange traded.

Futures contract: A forward-based contract to make or take delivery of a specified financial instrument, foreign currency or commodity during a specified period, at a specified price or yield. The contract often has provisions for a cash settlement. A futures contract is traded on a regulated exchange. As a result, it has less credit risk than a forward contract (McCarthy, 2000).

Equity Index: Stock market indices, which provided valuation basis for many derivatives. The majors suppliers of market data for this purpose are Dow Jones, FTSE (Financial Times Stock Index) and MSCI (Morgan Stanley Capital Index).

Index option: A contract is based on underlying issues that are indices. Most index options are based on various stock indices, although there are a wide variety of other indices that include debt and precious metals.

Liquidity: The relative ease and speed with which an asset can be converted to cash.

Notional amount: The number of currency units, shares, bushels, pounds or other units specified in a contract to determine settlement.

Risk: The degree of uncertainty associated with the return on an asset varies inversely with reward.

Secondary Market: A financial market in which securities has been previously issued (and is thus second hand) can be resold.

Swap: A forward-based contract or agreement generally between two counter-parties to exchange streams of cash flows over a specified period in the future.

Source: "Summary of Derivative Types." (Financial Accounting Standards Board, 1999) except where otherwise noted.

1.5 Trends and Issues in Bond Markets

Given the complexity and obscurity of these new types of convertible bonds and derivatives, it is reasonable to ask why they have become so popular and widely accessible. One explanation is that the rise of electronic trading has dramatically transformed world financial exchanges, making complex transactions based on fast-changing values much easier to conduct. The electronic trading revolution has transformed the major equity markets, and has now entered major commodity markets, like Chicago Board of Trade (CBOT), which had traditionally used a trading pit system of physical (paper) transfers. As a recent Financial Times report on this revolution explained,

The realization that trading methods were changing irrevocably with computerized, screen-based systems offering a cheaper alternative to the traditional, pit-based "open outcry" - dawned later in the US than in Europe. Nevertheless, by the time Eurex, the all-electronic German-Swiss exchange, had snared the long-term interest rate business from London, and France's Matif had also abandoned its trading floor, the message had become clear in Chicago, home to the US futures industry. By late 1998, all of the big US derivatives exchanges were acknowledging that electronic trading was an issue they needed to address, and accommodate in some form (Tait, 2000: S 1)

Electronic trading methods had first emerged in the secretive realm of merchant banking complex stock and bond transactions, as Eurobonds and Euro yen became a convenient medium of exchange for global corporations and banks to use in swaps, options and forward contracts for hedging and speculation.

Yet, even the old-fashioned "market-makers" of the New York Stock Exchange eventually went over to EDS. The most obvious and crucial application for electronic trading was in derivatives and convertible bonds. These included not only exchange-based transactions, but all OTC (over the counter) and purely private transactions, which also gained tremendous efficiency from the use of instantaneous electronic information and the ability to perform complex financial calculations for futures, swaps and options on the fly. Today, the dominant trend in financial market transactions--not just of convertible bonds but virtually all types of financial instruments, shares and commodities -- is computerized electronic trading, a system that extends today to the Internet and the huge new consumer market for online "day trading" (Marlin, 2000: 10).

1.6 Risk and Reward in Convertibles v. Indexed Bonds

US Treasury Inflation-Indexed securities were introduced by the Department of the Treasury in January 1997 as a solution to inflation increases. Like convertible bonds, these are fixed-income instruments and have a 5-yr. or a 10-yr. maturity date. This provides real investment returns and inflation protection. If inflation rises, this fund is a safe bet for conservative investors, much like the convertibles. Unlike other bonds the principal will adjust for inflation through the years. The Consumer Price Index (CPI) determines the rate of inflation.

In deflationary periods when principal value of bonds decline, the least amount bondholders will get back at maturity is the par amount stated on the date the bond was first issued. Bonds pay interest twice a year. Principal and interest are backed by the full faith and credit of the US government, affect which appeals to the conservative savings-oriented investors. The objective of this fund is to provide real investment returns and inflation protection. Portfolio managers meet this objective by generally investing 65 percent of the fund's total assets in US Treasury inflation-indexed securities. The fund also invests in other US securities not indexed to inflation. Historically inflation rates between 1926 and 1996 have been as high as 18.2 percent and as low as 10.3 percent (Vujvovich, 1998:40).

Even within the convertible bond and bond funds sector, the alternatives have significant differences in terms of risk and reward and overall volatility. Buy-and-hold investors, for example, will be better off with 30 year inflation protected securities, or TIPS (Treasury Inflation Protection Securities), than with conventional treasuries. TIPS work by indexing the principal for inflation. They are in general hard to understand and less liquid. Slowing inflation has also made TIPS less desirable. TIPS having a 4-percent coupon at $1,000 for a 30-yr. term yield $40 in the first year. If inflation rises 3 points, the principal will equal $1,030. The $30 gain plus interest equals a 7-percent total return. These treasury securities may be bought without commission with a minimum of $1,000 order at auction online via the Treasury Direct program, or over the telephone. For a fee, they may be purchased through a broker or bank.

Convertible bond funds, and bond funds generally, are an easy means of distributing and reducing risk. If the investor prefers not to hold the individual securities, a group of three mutual funds may be purchased as inflation-protection debt instead. The three mutual funds acting as a TIPS are Pimco Real Return Bond fund, 59 Wall Street Inflation-Indexed Securities fund and American Century Inflation-Adjusted Treasury fund. Pimco and 59 Wall Street typically invest at least 65 percent of assets in US and foreign inflation protected securities. American Century is 100 percent US issue. As with zero-coupon debt, it is best to hold inflation-protected assets in tax-deferred accounts such as 401 (k) or Investment Retirement Accounts. TIPS holders have to pay federal taxes on annual interest and the amount by which the principal is increased for inflation even if no principal for inflation is seen until the bond matures or is sold. Mutual funds are better for tax deferred accounts since they compound interest and principal over time as well as pay out interest and principal inflation rate adjustment. ("A New Leader... 1995:123).

Small investors are better off betting on convertibles and preferred markets through mutual funds offering diversification and research capability to track these markets. The IRS exempts 70 percent dividend income paid to corporations. Individual investors are not so fortunate, however. Straight preferred shares pay fixed or floating dividends, which are popular with utilities and banks investors. Individual investors must pay taxes on all dividend income. However, the reduction of the individual marginal tax rates after the 1986 legislation made it less oppressive to individuals (Stovall, 1993:87).

Fund and portfolio managers with the best performing convertibles (1995 data) used the following typical strategy with impressive return results:

INVESTMENT STRATEGY:
S & P 500      23.3%
30-YR. Treasury Bond     14.7%
Inflation Rate      2.9%

SMALL STOCK FUND WITH BIG RETURNS:
[1] = per Morningstar % of total assets March 31
[2] = per Morningstar % of total assets July 31
[3] = per Morningstar % of total assets May 31
[4] = per Morningstar % of total assets January 31

(Fidelity reports current allocations are similar)

[Fund Telephone] John Hancock Special Equities A
Annual return past 5 yrs. = 29. 1 % annualized Rate of Return
Assets (millions) = $470
Sales Load Charge = 5.00%
Largest Sector Holdings [1] 5 1 % technology
        [2] 11 %media& entertainment

[Fund Telephone] MFS Emerging Growth B
Annual return past 5 yrs. = 25.5% annualized Rate of Return
Assets (millions) = $1,600
Sales Load Charge = 4.00%
Largest Sector Holdings [1] 29% technology
        [3] 28% media & entertainment

[Fund Telephone] United New Concepts
Annual return past 5 yrs. = 22.8% annualized Rate of Return
Assets (millions) = $400
Sales Load Charge = 5.75%
Largest Sector Holdings [1] 37% technology
        13% healthcare

[Fund Telephone] Seligman Frontier A
Annual return past 5 yrs. = 22.2% annualized Rate of Return
Assets (millions) = $220
Sales Load Charge = 4.75%
Largest Sector Holdings [1] 3 2% technology
        15% media & entertainment

[Fund Telephone] Fidelity Low-Priced Stock
Annual return past 5 yrs. = 21.3% annualized Rate of Return
Assets (millions) = $2,900
Sales Load Charge = 3.00
Largest Sector Holdings[ 1] 16% technology
        [4] 11 % finance

1.7 Short Term Risk and Volatility

Obviously, opting to use convertibles or bond mutual funds eliminates not all risk. When the conversion value is very high, the investor is subject to significant downward price movement. The pure bond value will thus fall if the interest rates rise. The investor is at a disadvantage, moreover, since interest rates on convertibles are less than on non-convertible straight bonds of the same risk. Convertible bonds are also subject to the call provision. (Block and Hirt, 1989: Chpt. 19).

Options are contracts that give the holder the right to buy or sell an asset at some predetermined price within a specific time period. The call provision, or option, conveys the right to buy a share of stock at a set price called the "exercise", or striking price. Put options give the holder the right to sell the stock at the striking price. Either option has both a buyer and a seller. The buyer has the right to exercise the option. The seller, called the writer, must execute the transaction if the option is exercised. The seller who writes a call option on stock they own is considered to write covered options. A similar option written without the seller holding the underlying stock is called a "naked option." Companies or corporations whose stock options are written have nothing to do with the options market; they do not raise capital in this market, nor do they have any direct transactions in this market (Bringham and Gapenski, 199 1: Chpt. 18).

Again, convertible bond funds distribute this risk, but do not remove it entirely. A company desiring to shift outstanding debt to common stock can do so by forcing the conversion. Using the call provision, as discussed briefly above does this. When the value of the common stock goes up, the convertible security will move similarly. For example, Table 1. below shows that convertible debentures may significantly go up in value. Conversions may be forced when the conversion value exceeds the call price. Convertibles are initially offered with a conversion price at least 15 percent above the then-current market price of the common. In this case, forced conversions are encouraged by a "step-up" provision in the conversion price (the bond's face value), divided by the number of converted common stock shares. (Block and Hirt, 1989: Chpt. 19).

CHAPTER TWO
REVIEW OF THE LITERATURE

2.1 Introduction

Despite their outstanding risk-reward performance during the past two decades, US retail investors have largely neglected convertible bonds and mutual funds based in these hybrid securities. First emerging in volume at the start of the 1970s, the convertible market is still a specialized niche within fixed-income financial asset management. Although the number of exchange listed, dollar-denominated convertible bonds expanded rapidly at the of the 1990s as small-cap, high-tech firms tapped the market, convertible bonds still constitute only around 6 percent of all US corporate debt paper in circulation (Wells June 2000, np). Compared to both stocks and non-convertible bonds, convertible bonds are thinly traded in secondary markets formed through the disposal of initial allotments by institutional investors. Narrow, thin, and dominated by brokerage houses, mutual and pension funds, and asset management companies, the relatively "underdeveloped" structure of the convertible bond market still presents powerful deterrents to participation by the most knowledgeable of individual investors.

During the prolonged 1990s bull market in US equities, the vast majority of individual investors have fixed their attention on common stock and stock mutual funds as their means for gaining direct exposure to sharp equity appreciation, with conventional bonds and bond funds furnishing diversification and correlative stability to their portfolios. Having no designated place within the standard "stock/bond/cash" asset allocation models of individual investors, not only has convertible bond exposure been viewed as unnecessary or redundant, but the nature and valuation of these hybrid bond/equity warrant securities was regarded as an overly complicated task (Ritchie 1997, p.290).

If we review the research and market data, the reasons that non-institutional investors have neglected convertible bonds are plain enough. Nevertheless, although largely unrecognized by retail investors, during a number of rapidly growing, professionally managed convertible bond mutual funds, including Fidelity, Putnam and Vanguard funds have posted very solid results. With total annual returns among leading convertible bond funds consistently exceeding those of "balanced" (fixed-percentage stock/bond allocation) mutual funds, convertible bonds have captured most of the upside gain in equities, out-performing the S&P 500 in 1999. At the same time, during significant market declines, the Asian crisis of October, 1998 for example, convertible bonds have shown remarkable resiliency, falling far less than equities and "balanced" mutual funds. Given this performance by convertible bond funds, retail investors have good cause to consider anew the potential risks and rewards of convertible bond exposure obtained through a professionally managed mutual fund. Several such funds have demonstrated a technical ability to evaluate individual convertible bond securities and to make related tactical decisions, e.g., on bond conversion. This suggests that they have the strategic-analytical talent to manage a broad portfolio of securities for optimal long-term capital appreciation.

Despite their seeming complexity, retail investors can simply compare the overall performance of any given convertible bond mutual fund with either its peers or with the comparable alternatives like non-convertible bond, balanced or equity index mutual funds. They no longer even need a basic understanding of the nature of this asset class, its generic risks and rewards. Of greatest importance is development that has taken place in the late 1990s, the surge in convertible bond issues by small, digital technology and telecommunications firms. The quality of the holdings in convertible bond funds now varies dramatically, with the highest return in the sector generally being posted by funds with tech-weighted portfolios and far less impressive (but much less risky) gains being registered by more conservative fund managers. But with the upheaval in the tech stock sector in the last six months, this situation has changed dramatically, as we will see.

2.2 Recent Trends in Convertible Bond and Convertible Bond Mutual Funds

Given the high-tech company movement into convertible bond financing, investors need to consider whether to purchase convertible bond mutual fund shares and their selection of a particular fund. As Ritchie noted in 1997, the US convertible bond market has experienced two major transformations since its inception in the 1960s. During the first years of the US convertible bond market, the majority of convertible bond issuers were public utilities. Given their comparatively limited equity growth potential, the interest component of these securities provided the lion's share of the return, with their embedded equity call option providing only a modest contribution to total returns.

By the early 1970s, however, external-financing preferences of public utilities turned to other alternatives in straight bond issuing and bank debt, as small- and medium-size industrial companies came to denominate new convertible bond issuance (Ritchie 1997, p.290). Of the estimated $33.5 billion in convertible bonds currently trading on US exchanges, about half are issues of small to medium sized industrial, financial, and retail firms, companies that can be collectively characterized as "old economy issues." Their convertible bonds are tied to an asset class, e.g., the underlying common stock, that has shown robust, double-digit appreciation for the past two decades, and their convertible bonds have consequently acted more like stocks than fixed-income securities.

During the 1990s (and at a dramatically-accelerating pace), technology and telecommunications companies came to dominate initial public offering of the convertible bonds. In 1999 alone, the value of convertible bonds in circulation on secondary markets issued by high tech firms expanded from 29 percent of the aggregate for all exchange-listed convertible bonds to 45 percent (Wells January 2000, np.). As this shift toward high-tech issuance has occurred, the prospective rewards of the equity option embedded within convertible bonds have increased accordingly, accompanied by a correlative increase in the risks associated with convertible bonds and bond mutual funds.

At present, the total returns on convertible bonds are much closer to those of stocks than to those of fixed income securities. Indeed, 1999 was an especially good year for convertible bonds/bond funds as the underlying common stocks of high-tech companies rose dramatically (Wells June 2000, np.). Among all generic types of bonds/bond funds, convertibles were the only sub-class to perform well in the face of the US Federal Reserve Board's non-accommodative interest rate policies. Nevertheless, the risk associated with convertible bonds at large has mounted substantially while their interest payment component provided some "floor" to equity option downside risk. An increasing share of the convertible market (and of convertible bond mutual funds) is tied to very volatile movements in the price of small-cap growth stocks.

With these provisions in mind, the favorable performance of convertible bonds since the early 1980s has stimulated the establishment of several dozen convertible bond mutual funds. The first open-ended convertible bond funds appeared in the early 1970s and provided returns that was modestly greater than those of investment grade corporate/utility bonds (McDonald 2000, np.). Shortly thereafter, the first closed-end convertible bond funds made their appearance on major US stock exchanges (Nield 1997, 11-17). As it now stands, if we count multiple fund classes distinctly (e.g., "A," "B," "C," "D" and or "Y" shares), there are at least 62 open-ended convertible bond mutual funds available to the American investing public, along with some 10 closed-end funds specializing in such securities. As suggested in passing above, the composition, investment policies, and returns of these funds display very wide variation. On the one hand, such variation demands that investors grasp the basics of convertible bonds as a prelude to their assessment of a fund prospectus and an appraisal of its holdings. On the other hand, because of this wide variation among convertible bond mutual funds, individual investors can select from a very broad spectrum ranging from very low to comparatively high-risk securities.

2.3 The Nature of Underlying Securities

Along with preferred stock issues (some of which are also convertible into common stock), convertible bonds fall under the rubric of "hybrid" securities, having features that resemble both conventional bonds and equity call options. As John Ritchie succinctly puts it, "convertible securities are fixed income securities that permit the holder the right to acquire the common stock of the issuing corporation under specified conditions rather than by direct purchase in the stock market" (p.287). Typically (but not universally), convertible bonds pay a stipulated coupon interest rate and have a warrant into the common stock of the convertible bond issuer. Thus, according to Frank Fabozzi and Franco Modigliani:

A convertible bond is one that can be exchanged for a specified amount of another asset. The asset is typically the common stock of the issuing firm. There are issues that permit conversion into the common stock of a corporation other than that of the issuer of the bond; such issues are called exchangeable bonds. Some issues permit conversion into gold or some other precious metal (1992, p.216).

There are, in fact, variations upon conventional convertible bonds. Among these, Liquid Yield Option Notes (LYONS) were developed in mid-1980s to provide a "zero coupon" form of convertible bond (Nield 1997, p.20-7). As Fabozzi and Modigliani mentioned above, some convertible bonds permit conversion into a security other than the common stock of the issuer. Nevertheless, for the sake of simplicity, the discussion that follows will be confined to "standard" convertible bonds, i.e., coupon debt securities with equity warrant that can be converted at the holder's election into the issuer's common stock.

Michael Berman and Eduardo Schwartz (1992), have illustrated the central features of a conventional convertible bond through an extended example:

The terms of a typical convertible bond are as follows. Each $1,000 bond pays a coupon of $80 per year (eight percent) and can be converted at the option of the holder into a predetermined number of shares called the conversion ratio. The conversion option may also be expressed in terms of the conversion price; if the conversion ratio is 20 shares per bond, then the bond is said to be convertible into common shares at a conversion price of $1000/20 = $50. It is customary to distinguish between the straight debt value and the conversion value. The straight debt value is the current value of the shares into which the bond is convertible. Since the bond is convertible at the option of the holder, the value can never fall below the greater of the straight debt value and the conversion value. From the viewpoint of the purchaser, a convertible bond is similar to a straight bond plus a warrant to purchase common shares. While the holder of the bond has the right to convert it, the issuing corporation typically has the right to call the bond for redemption at a predetermined series of call prices; usually calls are prohibited in the first few years after issuance, and often the call privilege is further restricted unless the underlying stock is trading above a pre-specified multiple of the conversion price. When the bond is called the holder has the choice of converting it or of redeeming it at the call price"(Berman and Schwartz 1992, p.453).

From the standpoint of the convertible bondholder, the critical questions to consider are whether and when to convert the bond into a pre-specified number of common stock shares.

This decision rests on the market determinants of the issuer's common stock price performance. Nield has delineated the contours of the convertible bond conversion decision.

If the price of the underlying common stock rises sufficiently, the holder or a convertible can either exercise the security---acquiring stock at a price below market---or he can sell the convertible at a price that reflects the enhanced value of the underlying common stock. If the stock doesn't rise, the holder receives the interest income and, if held long enough, the redemption value at maturity...

If the price of the underlying security is depressed, the warrant-like conversion feature of the bond has little value, and the convertible is valued by the market as essentially a straight bond without a conversion feature. Once the share price starts to rebound, the conversion option becomes more valuable and the debt value begins to level out. If the stock price continues to soar, the bond will be valued mainly on the basis of its convertibility (Nield 1997, p.20-15).

As this description suggests, depending on the size of the conversion premium, convertible bonds will perform more or less like the common stock shares into which they can be converted at a future date.

Convertible bonds generally have a par-value interest rate that is lower than that of the issuer's "straight" bonds but typically higher than the dividend rate on its common stock (Ritchie 1997, pp.288, 292). Thus, for example, a standard convertible bond may offer a coupon interest rate of 6 percent as compared to an 8 percent rate on the issuer's non-convertible bonds of similar maturity and to an equity dividend rate on the issuer's common stock of 2 percent. Although shorter maturity issues are available on the secondary markets, newly issued convertible bonds are typically long-term securities with maturity schedules going out twenty-five to thirty years (Ibid., p.288). The vast majority of convertible bonds are callable at the behest of the issuer after a specified date. Typically a five to ten-year "grace" period must elapse from the date of original issuance before this call option can be exercised by the debtor (Nield 1997, p. 11-25).

The extent to which a convertible bond "acts like" a bond or a stock is conditional upon the size of the conversion premium, i.e., the price of the bond in excess of its present conversion value. On this count, Nield (1997) apprises us:

As with preferred shares, convertible bonds are primarily considered to be income-oriented assets based on their regular interest payments (which are usually made semi-annually). However, because they also offer the potential for substantial capital gains if the underlying common stock goes up in price, they don't always behave like pure fixed-income investments. In other words, their prices tend to go up and down more in response to moves in the price of the underlying common shares than to changing conditions in the interest-rate markets --- particularly if the common stock is trading above the bond's conversion price...

The degree to which a convertible bond acts more like a stock than a pure debt security depends primarily on the size of the conversion premium. If the premium is high, the convertible will act more like a bond, moving with market interest rates --- and, if it is low, the convertible will act more like a stock, tracking moves in the underlying common (Nield 1997, p.1 1-23).

Most convertible s traded on the secondary market have low conversion premiums, meaning that their value will more closely reflect price levels and movements in the issuer's common stock than it will price level s/movements of comparable quality and maturity corporate bonds. For example, the issuer's holding of personal non-convertible debt paper. In fact, as Laderman (1997) has calculated, in the early- and mid-1990s there was only a 20 percent correlation between convertible bond prices and price movements in investment grade corporate bonds (Laderman 1997, p.5 1).

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2.4 The Advantages and Disadvantages of Convertible Bond Investments

We can best approach the disadvantages of buying convertible bonds (or convertible bond mutual funds) by examining the reasons behind the seller's or issuer's decision to utilize this mode of capital acquisition as opposed to more conventional equity or non-convertible bond issuance. The benefits of convertible bonds to the seller/issuer are essentially two fold. First, convertible bonds permit the issuer to essentially "pre-sell" equity shares at a price above current market valuation of its common stock. Second, it allows the issuer to place debt paper at a lower interest rate than it would have to offer to attract demand for its non-convertible bonds (Berman and Schwartz 1992, p.453). The conversion price on convertible bonds is typically set some 20 percent higher than that of the common equity shares at the time of its issuance (Dunnan 1999, p.112). The disparity functions as a means of discouraging convertible bond holders from converting their bonds into common stock and thereby diluting the company's earnings per share (Nield 1997, p.20-13). Indeed, according to Knecht and McCowin (1989), from the buyer's perspective, "the underlying stock typically costs 20 percent to 30 percent more if acquired through the convertible than if purchased directly in the stock market" (p.98). At the same time, the seller can offer convertible bonds with coupon rates that are significantly lower than that of comparable straight bonds, typically two or three hundred basis points below its own corporate debt issues (Berman and Shwartz 1992, p.453).

It is important to note that a company's decision to issue convertible bonds typically evokes a negative response from its equity shareholders and the stock market at large. According to the "signaling" model developed by Dann and Mikkelson (1984), the issuing company's announcement of an impending convertible bond issue "signals" the equity market that the firm has considered prospects for a secondary offering of common stock and/or the issuance of corporate bonds. It must be concluded that neither of these alternative modes of financing is likely to meet with strong demand (pp.155-156). This, in turn, typically generates an erosion in the market's perception of the issuer's financial soundness, Dann and Mikkelson calculating that the common stock of convertible bond issuers drops an average of 2.85 percent on the day that a convertible bond IPO is announced by management.

Because it is a hybrid security, convertible bonds are exposed to the generic risks entailed in both bond and stock ownership. As with a straight, non-convertible bond, "the price an investor will pay for a (convertible) bond will depend in part on market interest rates, the risks associated with an issue and unique feature of the particular issue" (Fabozzi & Modigliani, 1992, pp.217-218). As with most fixed-income investments, convertible s are vulnerable to interest rate rise, depressing the value of the bond. Along with this risk, because the interest rate on convertible bonds is fixed to maturity, they are exposed to "Inflation" or "purchasing-power" risk. It is possible that the coupon rate on a convertible bond will actually be lower than the underlying inflation in the economy/currency of the issuer, leading to erosion of purchasing power at maturity. In addition, convertible bonds (like most fixed-income securities) carry with them reinvestment risk, credit or default risk, and call risk. Lastly, "foreign" convertible that are not denominated in the investors "home currency" (presumably US dollars) bear exchange rate currency risk (Fabozzi & Modigliani, 1992, pp.218-219).

In general, convertible bonds have higher risks associated with them than do straight investment-grade corporate bonds. They are subordinated debentures: in the event of the issuer's insolvency and/or entrance into bankruptcy, convertible bond holders stand "behind" holders of senior debt, including bank lenders and/or non-convertible bond holders, but ahead of both common and preferred equity shareholders (Ritchie 1997, p.288). In terms of security of capital then, convertible bonds are less risky than stocks but more risky than straight bonds.

Virtually all convertibles are subjecting to credit assessment by bond rating agencies. Thus, for example, after conducting an assessment of the convertible bond issue Standard & Poor's will assign it a rating of AAA, AA, A, BBB, BB, B, CCC, CC, or C (S&P's "D" rating being reserved for bond that are currently in default) (Ederington 1992, p.220). In this schema, the highest quality corporate bonds, "investment grade" bonds, are limited to those rated AAA, AA or A; BBB rated bonds (or triple Bs) are generally seen as "intermediate" grade debt; bonds rated BB or lower are regarded as "high-yield" or "junk" issues. According to a study conducted in 1989 by Edward Altman, the default rate on "triple-A" (AAA) bonds during the first ten years of maturity was less than 0.1 percent: the default rate on "triple B" bonds during that time span was 2.1 percent; corresponding default rates on BB and B rated bonds were 6.4 percent and 31.9 percent (p. 910).

Convertible bonds are usually assigned a rating that is one step below that of the issuer's non-convertible bonds (Pinchess & Mingo, 1973, p.14). Thus, for example, if an issuing firm's straight bonds are rated BBB, then its convertible bonds are likely to be assigned a rating of BB. Partially (but by no means exclusively) ranging as a consequence of this, more than half of all convertible bonds in circulation at present have ratings from BBB (intermediate grade) to B high-yield or junk) (Nield 1997, p. 11-23). The main reason for this, in Nield's view, is that most issuers of convertible bonds are far less creditworthy than issuers of investment grade debt paper.

In fact, one can say that the convertible bond market is dominated by smaller companies those without substantial assets or proven performance records. These are firm that would be unable to attract investors to their bonds were it not for the addition of a conversion feature. Thus, while an investment in preferred stock usually gives you a stake in high-quality utility companies or leading industrial corporations, an investment in convertible bond more often presents a play on second-tier companies, akin to a high-tech stock option.

It must be added that the risk profile of the convertible bond market has heightened substantially in the late 1990s as small, high-tech firms in computer technology/ telecommunications have come to account for more and more of the total market in this asset class. In addition, empirical studies have found that convertible bonds are more vulnerable to downgrades by rating agencies than are straight bonds (Ritchie 1997, p.293). In the event of a ratings downgrade, the market value of any convertible bond will necessarily decline independent of price movements in its associated common stock.

While convertible bonds are subject to the same risks as their non-convertible counterparts, the fact that their market value is also contingent upon the price of the common shares into which they can be converted exposes them to virtually all of the risks associated with equities as well. If the market price of the issuing firm's common stock declines, then, all else being equal, the market value of its convertible bonds will undergo commensurate erosion. Particularly as a greater percentage of total convertible bond issuance comes from "high-flying" technology and telecommunications firms, this asset class is vulnerable to severe volatility, including powerful downdrafts in market price such as have been seen in the second half of 2000.

Offsetting the combined disadvantages of a security that is vulnerable to the risks of bonds and stocks alike, it is the tandem benefits of a "floor" or safety net and an equity "kicker" that comprise the main attraction of convertible bonds. Given that equity dimension risk of convertible bonds is substantially greater than that of their bond dimension risk, the most significant advantage of these securities lies in the former. When the issuing company's common stock price drops, so does the convertible's value, but the interest income provision of the convertible bond functions as a floor or safety net, limiting or buffering the extent of the losses. "If the price of the underlying common stock declines in the market, the (convertible) bond can be expected to decline only to the point where it yields a satisfactory return on its value as a straight bond" (Ritchie 1997, p.292).

When set alongside other types of fixed-income securities, convertible bonds have much greater upside potential if, as expected, the price of the common stock into which the bond may be converted undergoes significant appreciation. They combine this upside potential --- the equity option --- with some downside risk protection --- the safety net feature. The yield from the bond component is enhanced by potentially larger returns if the underlying asset rises in value. A convertible can lie anywhere on the spectrum between a pure equity equivalent and a pure debt equivalent. If the conversion premium is high --- that is, the price of the convertible is well above its value if it were exchanged for stock --- the convertible acts like a bond, moving with changes in interest rates. If the conversion premium (the bond's value in excess of its conversion value) is low, the convertible acts like a stock, moving almost in tandem with the stock's price (Nield 1997, p.20-3). In essence, convertible bonds allow investors to participate in the stock market with less risk and to participate in the bond market with considerably greater prospects for capital appreciation than any other type of fixed-income security, including high-yield bonds.

Empirical research has yielded several rule-of-thumb estimates of convertible bond upside and downside parameters relative to associated common stock. According to an extensive historical series data analysis conducted by Goldman Sachs, convertible bonds appreciate in value by about 67 cents for every 1 dollar of common stock upside movement, but decline by only 50 cents for every I dollar of common stock downside movement (Wells, June 2000, np). Limiting their analysis to the convertible bonds in their own portfolio, the managers of the Putnam Convertible Income Fund, assert that convertible bonds offer an even more favorable upside/downside ratio, example, an average 75 percent gain in the case of upside appreciation in associated common stock, with only 50 percent of downside risk in common stock (Laderman 1997, p.52). Lastly, Certified Financial Planners & Registered Advisors (2000) cites Salomon Brothers finding that convertible bonds actually offer 118 percent of the upside but only 50 percent of downside of associated common stock. Plainly, then, the "floor" of "safety net" feature of convertible bonds does afford downside protection, while the equity kicker allows convertible bond holders to capture most (or, in the Salomon Brothers study, even more) of the gains in he issuer's common stock.

There are several added benefits to owners of convertible bonds. The most important of these is that, as a distinct asset class, convertible bonds offer the investor a means for diversifying outside of both stocks and bonds. On this subject Nield (1997) says that "...adding convertible securities to a diversified investment portfolio tends to boost the portfolio's total return over time, since their value is likely to be going up while the value of other assets decreases. Convertibles at the same time will tend to lower the overall risk of many portfolios as measured by the standard deviation of the returns of each type of asset in the investment mix" (Nield 1997, p. 31).

Nield also mentions that because companies that have a relatively small market capitalization now typically issue convertible bonds, they provide a means for investors to diversify away from large-cap equity issues into smaller, high-growth companies (Nield 1997, pp 20-24). Concurrently, convertible bonds generate substantial interest payments, thereby contributing to internal portfolio cash flow and reducing overall portfolio value volatility. Lastly, according to Nancy Dunnan (1999), "for experienced investors, convertible offer excellent vehicles for hedging-buying one security and simultaneously selling short its related security" (Dunnan, 1999, p. 114).

The larger question of why convertible (both bonds and convertible preferred stock) offer such "bargains" to investors has never been conclusively answered. One thesis mentioned by Nield is that institutional investors dominate the primary market for convertible bond issuance. A standard pattern among institutional holders of convertible bonds is to acquire these securities when they are originally issued, and then "flip" them into the secondary market before their actual market value is full realized (Nield 1997, p.20-4). As noted at the start of this study, when compared to equities, convertible bond markets are thinly traded. Under such conditions, these securities are even more likely to be available at prices below their actual or "fair" value. From one perspective at least, the very "inefficiencies" of the secondary market for convertible bonds affords bargains to retail investors.

2.5 Historical Returns from Convertible Bonds

In the main, convertible bonds tend to perform best under conditions that favor small-cap stocks. These include periods of stable or declining interest rates, which both enhance the value of the convertible bond's fixed-income dimension and, at the same time, contribute to the positive financial performance of convertible bond issuers, chiefly small- or medium-sized companies, by lowering their capital costs and stimulating demand for their products and services. On the other hand, during periods of rising interest rates and/or declining equity values, particularly in small-capitalization stocks, convertible bonds will typically suffer adverse price movements (Dunnan 1999, p. 113).

Several empirical studies have shown that convertible bonds have offered an attractive alternative to a mixture of stocks and bonds over the long term. Between 1957 and 1992, a Merrill Lynch index of convertible bonds posted an average annual total return of 8.30 percent. Although this is less than the 10.53 percent average annual return on common stocks within the Standard & Poors 500, it is a good deal higher than the returns on long-term investment grade corporate bonds (6.85 percent annual return) and intermediate-term investment grade corporate bonds (7.26 percent) over that thirty-five year time span. More remarkably, if we limit the temporal scope of the analysis, we find that between 1973 and 1992, the convertible bonds in the Merrill Lynch index actually outperformed equities in the S&P 500 index in terms of total average annual returns (Nield 1997, p.20-32).

The early 1990s furnish us with tandem examples of "good" and "bad" macroeconomic conditions for convertible bonds. As will be further noted when we turn to the recent performance of convertible bond funds, in 1991, 1992, and 1993, a declining interest rate environment enabled convertible bonds to outperform both common stocks (in the S&P 500) and corporate bonds. However, in 1994, as the Federal Reserve shifted to a tight monetary policy, interest rates rose, equity markets were depressed and bond prices declined substantially. As a result, convertible bonds suffered a "double whammy" as both their fixed-income and the equity call option dimensions experienced an erosion in value (Brill 2000, np.). In the first half of 1994, Merrill Lynch's convertible bond index fell by 6.52 percent. This was a greater decline than 4.10 percent downturn on Merrill's index of government and corporate bonds and, even more startling, even greater than 3.47 decline for the S&P 500 over the same six month time span (Nield 1997, p.20-13). It should be noted that the Russell 2000 index of small-cap stocks fell even more than ML's convertible bond index (i.e., 10.7 percent) during the first half of 1994. Nonetheless, although convertible bonds do furnish a "floor" or "safety net" to a stock market sell-off, under adverse conditions their losses can be more severe than those of "blue chip" stocks.

More recently, in 1999 the Merrill Lynch index of convertible bonds posted an annual return of 30.1 percent, again surpassing the gain on the S&P 500. During the volatile first half of the year 2000, convertible bonds showed to good advantage. During the first five months of that year, while the S&P index posted a 2.58 percent decline, the ML index of convertible bonds actually rose 1.0 percent. As impressive, during first three weeks of June 2000, while S&P index funds recovered some 2.58 percent from its April-May swoon, convertible bond funds rose by 5.5 percent (Wells June 2000, np.). Of late, then, convertible bonds have demonstrated their inherent capacity to capture most of the upside gains registered by their associated common stocks, while experiencing only a fraction of the downside losses occurring in the underlying equities

2.6 Convertible Bond Mutual Funds

To a much greater extent than investment grade bonds, intermediate grade bonds, or even blue-chip stocks, the risks and uncertainties of holding convertible bonds can be greatly mitigated through the alternative of a convertible bond mutual fund. As Nield (1997) puts it, "with a mutual fund, you can minimize the excess default risk in convertible bonds, greatly reduce the company specific risks related to ratings downgrades or management miscues and virtually eliminate the reinvestment risk that plagues many investors in fixed-income securities" (pp. 11-26). By electing to obtain exposure to convertibles through a mutual fund, investors transfer the relatively complex task of valuing and selecting these securities into the hands of professional specialists. At the same time, given that convertible bonds are generally rated BBB or below (from intermediate to high-yield or junk status), a mutual fund furnishes a degree of diversification that an individual investor cannot achieve unless he or she is able (and willing) to purchase at least ten or twelve issues in minimum pieces of $10,000. Indeed, most retail-class convertible bond mutual funds have very modest minimum investment thresholds, typically requiring a minimal initial investment of $1,000. For the "average" retail investor with a portfolio of less than $1 million in financial assets, mutual funds are practically superior to the construction of a convertible bond portfolio.

However, it must be recognized that the quality, the investment strategy, and the composition of convertible bond mutual funds vary dramatically. To begin, most convertible bond funds are obliged by their charter to hold a minimal amount of deployed assets in convertible bonds (typically 70 percent). At the same time, many convertible "bond" funds also hold other types of hybrid securities, most notably both non-convertible and convertible stock. But the greatest source of variance among convertible bond funds lies in the nature and quality of the issuing companies and the associated come stock into which these bonds may be converted. As emphasized throughout this report, the profile of convertible bond issuers has undergone a sea change during the past decade. At present, around half of all convertible bonds in circulation have been issued by "high-tech" companies, primarily small- and medium-sized enterprises whose common stock trades at an earnings multiple well above the average for the S&P 500 and, in fact, for the Russell 2000. Today, there is much greater risk (and greater potential reward) in convertible bonds and bond funds than there was just two or three years ago. The existence of a "safety net" feature in the form of the interest coupon should not blind prospective retail investors to the fact that these instruments entail risks that are much closer to equities than to other sub-classes of fixed-income securities.

2.7 Performance of Convertible Bond Funds: The 1980s and 1990s

In attempting to assess the performance of convertible mutual bond funds as a whole, we are presented with a dilemma in the choice of an appropriate criteria or "yardstick" for comparison. Although convertible bond funds are nominally bond funds, their hybrid character argues for comparison against funds comprised of both stocks and bonds, i.e., so-called "balanced" funds. Set alongside "balanced mutual funds," convertible bond funds have posted superior results, outperforming the former throughout the 1980s and the 1990s (Wells June, 2000). Indeed, the annual return from convertible bond funds has surpassed S&P 500-indexed equity mutual funds in four of the past ten years (1991, 1992, 1993 and 1999). Most recently, while the average annual rate of return for all US equity mutual funds in 1999 was around 24 percent, convertible bond funds listed on US exchanges returned over 30 percent in that year; indeed, the twenty-five highest performing convertible bond funds turned in a stellar return rate of 35 percent for 1999.

In a recent article on some of the leading convertible bond mutual funds, Maureen Wells (June 2000) focused her attention on three representative funds and their performance during the first five months of the year 2000. During that period, the first of these, the Mainstay Convertible Bond Fund (MCSVX), had a total return of 7.3 percent. The Mainstay Fund takes a conservative approach the convertible bonds: most of its holdings are rated BBB or better; most have a high conversion premium; and, consequently, the fund's holdings tend to act more like fixed-income securities than like equities. As for the second fund investigated by Wells, Nations Convertible Securities Fund (PHIKX), it posted a 9.44 percent total return during the first half of 2000. It is essential to note, however, that the Nations convertible fund includes not only convertible bonds but also convertible preferred stock and straightforward equities within its portfolio.

The third, the largest convertible bond fund registered in the United States (and, in fact, the largest convertible bond fund in the world) Fidelity Convertible Securities Fund (FCONVERTIBLESX), was up a robust 11.57 percent during the first six months of the year 2000. According to Wells, this higher rate of return is due primarily to the fact that the Fidelity fund invests primarily in the issues of technology and telecommunications companies.

Among the best performing (if the smallest and least well known) of convertible bond funds, Calamos Convertible Bond Fund, is one of the few funds in its class to receive a "four star" rating from the Morning star mutual fund rating service. This fund is an offering of Calamos Capital, an asset management firm that has over $4.5 billion in assets under management, the bulk of these assets being held in the accounts of institutional investors. Its convertible bond retail fund, however, is relatively small, with a total value of $160 million. It is also among the highest-performing convertible bonds, generating an outstanding 36 percent gain for shareholders during the first six months of 2000 (Brill 2000, np.). This follows a 35 percent gain in 1999, a time when Calamos fund managers relied heavily upon high-tech related issues to achieve returns that surpassed the S&P 500 by a significant margin.

In her interview with fund manager Nicholas Calamos, Maria Brill (2000) found that the technology company weighting of his fund increased from 25 percent of total portfolio value at the start of 1999 to 45 percent by year's end. Nevertheless, as of June 2000, the fund's manager was moving out of "high-tech" issues and into the convertible bonds of insurance and retail company issuers, e.g., Costco. It is apparent from this profile that under current conditions, outstanding gains can be posted by convertible bond funds, if the fund manager is actively engaged in re-assessing the risks and rewards of individual issues, as has been done at Calamos.

2.8 US-Exchange Listed Open-Ended and Closed-Ended \Convertible Funds

According to Morning star, a recognized leader in the evaluation of mutual funds at large, as on mid-2000, there were 62 open-ended convertible bond mutual funds actively traded in the United States. However, because some fund families offer more than one class of fund, e.g., a-class and b-class shares, there are currently 26 convertible bond funds. They are:

1. Ariston Convertible Bond Fund (I class) with a 4 star rating from Morning star.

2. Calamos Convertible Securities (4 classes) all having 4 star ratings.

3. Conseco Convertible Securities (4 classes) not rated by Morningstar

4. Davis Convertible Securities (4 classes) all have a 3 star rating

5. Fidelity Convertible Bond Fund (I class) with a 4 star rating and 16.49 percent YTD return between January and September 2000.

6. Franklin Convertible Bond Fund (2 classes) all having 3 star ratings, with a YTD of 17.03 percent (a-class) and 16.48 (b-class)

7. Gabelli Global Convertibles (1 class) with a 2 star rating, a negative 8.64 percent return for the first nine months of 2000, the only listed convertible bond fund holding foreign securities.

8. Harris Insight Convertible Bond Fund (2 classes) both rated 3 stars.

9. Morgan Stanley Dean Witter (4 classes), all 3 stars with positive YTD returns ranging from 10 to 11 percent

10. Mainstay (3 classes) all 4 stars with classes returning 11 to 12 percent during the first nine months of the year

11. Merrill Lynch Convertible Securities (4 classes) with a 2 star rating on three classes and a 1 star rating on class C, suffering a negative YTD return of -2.00 to -3.00 percent.

12. Nation's Convertibles (3 classes) all rated 4 stars, with a positive 13.79 percent positive YTD return.

13. Nicholas Applegate Convertible Fund (1 class), 1 of two CONVERTIBLE bond fund families to earn a five star rating from Morning star, with a "conservative" style and a 7.23 percent return between January and September, 2000./

14. Northern Income Fund (1 class), rated 3 stars.

15. Oppenheimer Convertible Securities (4 classes) all 3 or 4 stars, with a positive YTD of 3.09 percent

16. PIMCO convertible (1 class) not rated

17. Pilgrim Convertible (4 classes) all rated 5 stars, with an average 7.61 percent positive YTD return.

18. Pioneer Convertible Securities Fund (4 classes) not rated by Morning star with positive YTD returns of about 2 percent.

19. Putnam Convertible Bond Fund (3 classes) all 3 stars, suffering a minus 1.0 percent YTD performance.

20. Rock haven Securities Fund (I class) not rated by Morning star

21. Smith Barney (3 classes) with a 2 star rating but a positive 11. 5 percent YTD return.

22. TCW Galileo (1 class) 4 star-rated, with a positive 17.0 YTD return

23. Value Line CONVERTIBLE Bond Find (1 class) 3 stars.

24. Van Kampen Harbor Convertible Fund (4 classes) 3 stars

25. Vanguard Convertible Bond Fund (1 class) 3 stars

26. Victory Convertible Bond (1 class) 3 star rated.
     (Source: Morningstar.com 25 September, 2000).

Going over this roster, we find that the largest convertible bond fund is Fidelity's Convertible Bond Fund, with some $2.1 billion in assets under management, followed by the Putnam Convertibles Bond Fund: Class A, with a total value of $1.2 billion. Most convertible bond funds are relatively small: of the 62 funds listed above, half have assets of $400 million or less. During the first nine months of the year 2000, the best performing convertible bonds were Franklin, Fidelity, and TCW Galileo, all of which posted gains of between 16 percent to 17 percent. The worst performing fund during this period was the Gabelli Global Convertible Find, with a minus 8.64 percent return. This fund, significantly, is the only US-registered convertible bond fund holder of non-US assets; it was Gabelli's exposure to Asian convertible bonds that undercut its performance during the first half of 2000. The annual expense ratios on these convertible bonds also vary substantially. The Vanguard convertible Bond Fund has the lowest expense ratio at 0.55 percent, followed closely by its perennial rival, Fidelity, with an 0.82 percent expense ratio. The highest expense ratio within the subset was the Gabelli Convertible Bond Fund (2.63 percent), the ratio being a function of the higher cost of research required to evaluate and acquire non-US convertible bonds. As for minimum investment requirements, virtually all retail investor classes have a minimum of $1,000 to $2,500.

Turning to longer-term performance of the eight open-ended convertible bond funds trading in the United States with a ten year track record, the Calamos Convertible Bond Fund has the best 10-year performance, turning in an average annual return of 20.66 percent, i.e., higher than that of S&P 500-index funds. The Fidelity Convertible Bond Fund comes in second (an average annual return of 20.23 percent for the past ten years), with the Ariston Convertible Bond Fund taking third place (18.86 percent a year for the past decade). For the past five years, Calamos again heads the list (26.73 percent return on average between 1995 and 2000), followed closely by the Nicholas Applegate Convertible Bond Fund (26.12 percent) and the Pilgrim Convertible Securities Fund (26.00 percent average annual return). For the past three years (mid-1997 to mid-2000), the Ariston Fund has shown the best performance by far (32.49 percent annual average), with Nicholas Applegate (29.36 percent) and Pilgrim Convertible (four classes with average of 29.00 percent) coming in second and third. Lastly, between mid-1999 and mid-2000, the Ariston Convertible Bond fund enjoyed a whopping 86.24 percent gain, followed by the Fidelity Convertible Bond Fund (56.62 percent) and the TCW Galileo Convertible Bond Fund (55.23 percent). All three of the one-year leaders held portfolios with a preponderance of technology/telecommunications company convertible bonds.

In addition to open-ended convertible bond funds, there are ten closed-ended convertible bond funds trading on the New York Stock Exchange, the American Stock Exchange or the NASDAQ over-the-counter market in a manner similar to equities. They are:

1. Bancroft Convertible (symbol B convertible on the Amex exchange), with a 25.4 percent 52-week return.

2. Castle Convertibles (convertible F on the Amex) with a 16.7 percent 52-week return

3. Ellsworth Convertibles (ECF on the Amex) with a 27.0 percent 52-week return

4. Gabelli Convertible Securities (G convertible on the NYSE) with a 2.5 percent 52-week return

5. Lincoln Convertibles (LNV on the NYSE) with a 45 percent 52 week return.

6. Putnam Convertible Opportunities (P convertible on the NYC) with a 9.3 percent 52-week return.

7. Putnam Hi Income Convertible (PCF on the NYSE) with a 1.9 percent 52-week return

8. Renaissance Capital Growth & Income III (sold over the counter under the symbol RENN) with a 52.1 percent 52-week return.

9. TCW Convertible Securities (convertible T on the NYSE) with a 36.3 percent 52-week return

10. Van Kampen Convertible Securities (VXS on the NYSE) with a 81.3 percent 52-week return.
     (Source: Wall Street Journal, 20 September 2000, p. C-15).

All of these closed-end funds trade at a discount to their NAV that averages 12 percent, with largest discount on the Castle Convertible Fund (over 20 percent) and the smallest discount on Putnam Hi Income Convertible (2.6 percent).

CHAPTER THREE
IMETHODOLOGY AND CASE EXAMPLE DATA ANALYSIS

3.1 Overview of Method

The research method of this study is the comparative analysis of case examples, based on the data on returns from convertible bond issues and convertible bond funds in recent years. Examples of successful and unsuccessful issues will be cited in support of the research questions of the study. These comparisons provide the basis for my answers.

A basic method of comparative analysis is the table of price vs. yield date for a group of comparable group of bonds:

Table 1

Successful Convertible Bonds Not Yet Called as of Oct 1987
Issue, Coupon, Maturity	Market Price	Current Call Price	Current Yield	Dividend Yield
Crane Co. 5.00% 1993	$5,945.00	$1,000.00**	0.84%	2.73%
Pepsi Co. Inc. 4.75% 1996	5,630.00	1,012.30	0.84	1.71
Ralston Purina Co. 5.75% 2000	5,275.00	1,023.00	1.09	1.53
Rochester Tel. Corp. 4.75% 1994	2,145.62	1,011.90	2.21	5.35
Saint Regis Corp. 4.875% 1995	3,977.50	1,012.20	1.23	1.89
Sherwin Williams 6.25% 1995	5,890.00	1,007.40	1.06	1.65
* * Initially $ 1,100

(Source: Block and Hirt, 1989:Chpt. 19)

3.2 Description of Procedures

The first step in the analysis is to compare the original coupon rates with the current rates. The coupon rates of the convertible bonds in Table 1 are relatively low, compared to the existing coupon rates of 9.5 to 12.5 percent in October 1987 for straight bonds of the same risk classification. Suppose then, for example, that Crane Co. called in the bonds for conversion. When the bonds were issued the corporation established a provision to call in the bond at 10 percent above the par value. That is, the $1,000.00 value was redeemable at $1,100.00. Most bonds have an initial 5 to 10 percent call premium, which depreciates over time.

At the time of issue, investors pay a conversion premium on the convertible. That is, the investors pay the equivalent of the market value of the convertible bond minus the conversion value. The conversion value is the conversion ratio (the number of shares of common stock into which the security may be converted), times the market price per share of common stock. The conversion price is the face value of the bond divided by the conversion ratio. As a result, the price of the convertible exceeds both the pure bond value and the conversion value. If the market price of the common stock exceeds the conversion price, the market value of the bond will rise above its par value to the conversion value or higher. Adversely, the value of the convertible bond is limited by its pure bond value.

In general, a bond is callable if the issuer can redeem the bond prior to maturity. A callable bond likely will be called if the current interest rates are well below an outstanding bond's coupon rate. The estimated expected rate of return on the bond is known as the yield to call. The yield to call as opposed to the yield to maturity, is calculated as follows:

The bond valuation model must be adjusted when interest is paid semiannually:

V = (I/2)(PVIFAk/2,2n) + M (PVIFk/2,2n)
     (Bringham & Gapenski, 1991:Chpt. 18).

Other factors to consider are the indentures or contractual terms of the convertible bond. The indentures of most convertibles contain an antidilution clause. This clause states the conversion ration may be raised, or the conversion price lowered, by the same percentage amount of any common stock dividend, corporate spin-off or split (Stovall, 1993:87).

Dilution effects are significant for reporting purposes as well. Until 1969 all convertible securities, warrants and other dilutive securities were not required to be adequately reflected in financial reports (as earnings per share). Since all of these types of securities have the potential to generate additional common stock at some point in the future, the effects of dilution need to be considered. There are two exacting ways earnings per share must be reported:

A. Primary earnings =       Adjusted earnings after taxes
     per share           Outstanding shares + Common Stock Equivalents

** Where Common Stock Equiv. include warrants, convertibles, and any other securities options that pay less than two-thirds the average Aa bond yield at the time of issue

Finally, the analysis must consider the final conversion effect on book value. When bonds are converted into stock, the liability changes into the owner's equity. The contribution for the shares issued is the carrying amount of the converted bonds, which becomes the book value of the capital contributed for the new shares. (Table 2 below).

TABLE 2:
CONVERSION RECORD ENTRY

May 1

Bonds Payable Discount on Bonds Payable Common Stock Contribute Capital in Excess of Par Value Common Stock To record the coonversion of bonds

100,00

800.00 900,000.00 9,200.00

(Source: Larson and Pyle, 1986:488)

From this two-stage comparative analysis of comparable bond funds, a final evaluation of the long-term strengths, weaknesses and risk-reward factors for a fund composed of a group of convertible bonds can be compiled.

CHAPTER FOUR
FINDINGS FOR ALTERNATIVES

4.1 Foreign vs. Domestic Convertibles

Many companies and corporations sell dollar-denominated convertible bonds to foreign investors. The major market for foreign bond sales is Western Europe, where the most developed infrastructure for Eurobonds and other derivative instruments has developed. For foreign investors, the safety of the convertibles and the opportunity to gain from increases in American stock prices are the attractions. Selling bonds outside the United States enables the American companies to skirt capital transfer restrictions and to raise dollars outside the US in a relatively secure and private market. (Block and Hirt, 1989: Chpt. 19).

The dramatic growth in convertible bond issues is by no means limited to the United States and American firms, however. In 1997, China first began permitting state-owned firms to issue convertible bonds. This change in financial regulations was considered a major first step towards privatization ("A sideways move," 1997:40). In 1997, Japan experienced a sustained banking crisis as a result of excessive and nonrestrictive lending practices. Investors took advantage of convertible bonds and funds due to the uncertain market and the perceived risk of bank savings and checking accounts. The Japanese government hoped that time and a noncompetitive operating environment would resolve their plight, but this was not to be the case.

Following the bank crisis of 1997, Prime Minister Ryntaro Hashimoto ordered the Prime Minister of Finance to deregulate the Japanese banks. Large profits were conceivably made from Japan's financial distress, as stock prices swing between periods of excessive over-evaluation and under-evaluation and investors waited to see how the situation played out. Many anomalies developed as a result. For example, Mitsubishi 3 bonds of 2002, trading in 1997 on the New York Stock Exchange at $980 a share, had an interesting conversion feature - the exchange rate increased. (Dravo, 1997:126).

In another case example, a British cable and telecom company, Telewest Communications, issued a convertible bond equivalent to $1,600, with a 5.25-percent annual coupon, in February 1999. Each bond may be exchanged in eight years from the date of issuance for 307.7 shares of Telewest stock. If the investor does not exchange the bond for shares at maturity, the $1,600 face value will be repaid. As of May 2000, the Telewest bond price had increased to $2,100, with a conversion premium of 11.37 percent over the current stock price at that time. Since the market peaked in March 2000, however, the stock dropped 22 percent, and the bond itself declined 18 percent. Regardless of these movements, as of May 2000, the underlying stock overall had climbed 50 percent and the bond had risen 31 percent. ("It's a Stock for the Ups...," 2000:70).

The size of this market makes its volatility even more interesting. The convertible market in Europe was worth approximately US$115 billion in the spring of 2000. Telecom, media and technology sectors made up one third of that $115 billion. It is now anticipated that as the New Economy expands, and companies in these areas seek more capital, convertible market growth will prove inevitable. In Germany, Mannesmann's most recent issue targeted 10 percent retail investors. "It's a Stock for the Ups ...," 2000:70). In short, convertibles are expected to develop a broader investor base as time goes on.

If you want to "get in now", recommends Grant Mackkie, head of international convertible research in Lehman Brothers in London, the timing is right. He has suggested a French telecom issue that is eventually exchangeable into a different company. The convertible bond example Mr. Mackie cites in the May 2000 report is the French Telecom issue, which converts into Panafon Hellenic Telecom, a Greek mobile phone company.

Another international option is GAM's Special Bond Funds, which come in sterling, Swiss franc, and dollar denominations. In this regard, the new convertible bonds are as risk diversified and multi-currency denominated as any of the Eurobond - Euro yen offerings in the derivatives markets. The upside potential of stock growth is somewhat sacrificed when investing in convertibles, but considering the volatility of tech stocks over the last year or so, convertibles can be a risk worth taking and are available at a bargain price ("It's a Stock for the Ups ... 2000:70).

4.2 US Convertible Bond Sampling

This basic trade?off between equity share risk and reward is being touted as one of the most attractive features of the convertible bond instruments. Recent convertible bond offerings have been billed as being "half the risk, two-thirds the gain", as they appear to be a safe port in a turbulent and volatile financial market:

TABLE 3:
CURRENT CONVERTIBLE BOND OFFERINGS FIRST QUARTER 2000

(Source: "It's a Stock for the Up 2000:70).

Issuance of convertible bonds in the United States has increased steadily for more than twelve months, as NASDAQ and the tech stock prices have declined. As of December 1999, there were approximately $140 billion convertibles in the market. Between 1998 and 1999, the Merrill Lynch "All US Convertibles Index" had reported a total return of 30 percent for its listings. Although interest rates are steadily rising as well, depressing the pure bond value of the convertibles, the technology sector still accounts for a good portion of the issuance. Approximately $33 billion (gross issuance) in 1999 was from technology and Web companies. The trick is in picking the right convertible. There are many out there to choose from. (Gorham, "Chicken Little Stocks...,"1999:200).

Since convertible bonds are issued at par value (that is to say, their redemption value) the price will typically represent a 20 to 30 percent premium over the underlying equity value, if converted immediately. Generally speaking, the yield on the typical convertible bond will be better than what would be gotten on the common stock, but worse than what a non-convertible or straight bond would obtain. (Gorham, "Chicken Little Stocks..." 1999:200).

An investor trading in convertibles in high quality companies can ideally expect to capture a total return of 70 percent of a significantly upward move in the underlying stock, and can expect to experience a 50 percent loss if the common stock were to fall by a like amount. One must keep in mind that stocks are suppose to appreciate over time, so this example is not the windfall it may appear to be. (Gorham, "Chicken Little Stocks..."1999:200).

For example, when Amazon.com issued convertible bonds in January 1999, the $1,000 bonds carried a 4.75 percent coupon, and the right to be converted into Amazon.com shares worth $787 at that time. There was a $213 conversion premium, or equity premium, on the bond. Over the time of appreciation, the reduced risk convertible buyers experience may tend to find them lagging behind common stock holders in the long term. (Gorham, "Chicken Little Stocks...1999:200). Since January 1999, Amazon.com has seen some good times and some bad times. As of July 2000, common shares fell to $50. The convertibles went down with the sinking ship. Amazon's 4.74 percent convertible due in 2009 fell from a high of $1,530 per $1,000 of face value to $785 as of July 2000. Like most bonds, the Amazon 4.75s pay semiannual interest, have a maturity date, and are callable. Even though the convertible has fallen significantly, the Amazon issue has kept its low conversion premium and the bond closely tracks the underlying stock. If Amazon regains momentum, the common stock is a better buy than the convertible bonds. According to David Sherman of hedge fund Cohanzick Management, the way to protect the investment is to short the underlying equity. (Gorham, "Rag-Top Bonds," 2000:270).

The other Internet giant, America Online put out a 4-percent convertible bond in November 1997, falling due in 2002. At the time of issuance the bond was convertible into 153.3 shares worth $714, when the convert was floated. AOL shares exploded in value by December 1999, and along with them the convertibles soared. By December 1999 the conversion value had climbed to $11,630, and the price of the convertible was practically equal. The par value lying far below the price of the convertible did not at that time offer much of a safety net. As a result, the convertible acts like a common stock, losing almost its entire fixed-income characteristic. If AOL common shares plummet, they will take the convertibles with them in this instance. (Gorham, "Chicken Little Stocks...1999:200).

Amazon.com is not the only tech convertible to take a beating in the recent volatile markets (Gorham, "Rag-Top Bonds," 2000:70). Scott Lange, head of US convertible securities advises to choose a convertible that with conversion premiums in the 15-40 percent range. This balances the risks and rewards of stocks and bonds. Another factor for investors to consider is the payback period. This is the number of years it takes to earn back the conversion premium, via a yield higher than the yield on the underlying common. Summarily, the ideal is a convertible with either a short payback period or a modest premium over the pure bond value. Investors should keep in mind the fact that the convertible preferred tend to have a higher bond premium, since they are positioned lower in the capital structure. Some of the publications helpful for convertible analysis are the Value Line Convertible Survey and the Bloomberg quote terminals. Online, ConvertBond.com offers pricing and current bond news. (Gorham, "Chicken Little Stocks..." 1999:200).

New convertible bonds are continually being offered. As of November 15, 2000, Province Healthcare Co., SpectraSite, and Solectron all offered convertibles. Province Healthcare, a Tennessee-based company that owns and leases 16 acute-care hospitals in nine states, priced $125 million in 5-year convertible bonds. Buyers received a 4.5-percent coupon, with a conversion premium of 23 percent. The offer includes three years of hard call protection, an attractive feature in today's markets (Ablan, "Province Healthcare 2000:newswire).

Another bond issuer, SpectraSite, a North Carolina-based company, builds, leases and manages cellular, paging and mobile radio services towers. SpectraSite priced $200 million 10-year convertible bonds, which include a coupon of 6.75-percent and a conversion premium of 15 percent. The offering also includes three years hard call protection ("Ablan, SpectraSite Prices..." 2000: newswire).

Solectron Corporation is a US electronics manufacturer currently pricing $1.5 billion in proceeds of zero-coupon convertible bonds. These are 20-year LYONS, or liquid yield option notes, and include a yield-to-maturity of 3.25-percent and conversion premium of 32-percent. The convertibles have a three-year put feature. Moody's Investors Services rate Solectron's senior unsecured notes as a Baa3. (Ablan, "Solectron Prices..," 2000:newswire).

As these examples suggest, the convertible bond market is growing in unprecedented fashion and is rapidly becoming a major player in the wider bond market. Particularly in the volatile high tech sector, convertible bonds are becoming an important alternative to straight equity issues. They offer a greater degree of risk protection, a diversity of investment options in the future, and a higher return than many conventional financial instruments.

4.3 Results

Q. 1. Are convertible bonds necessarily the best alternative to conventional stocks and bonds under present market conditions?"

As we stated at the beginning of this paper, convertible bond funds are only one option available in the financial market, and they are used to aid smaller companies as well as individual investors in achieving safe fixed income potential with less risk during inflationary periods. Although it is not the only hybrid bond option, it is one of the more desirable bond funds. The primary topic question, "Are convertible bonds necessarily the best alternative to conventional stocks and bonds under present market conditions?" could best be summarized as being dependent upon time-varying economic and financial situations and the environment at the time of decision. Current inflation factors, tax status, payback period, equity risk and market returns are among the major considerations.

Q. 2 "How long would this alternative be preferable?"

Convertible bonds have emerged in recent years as a useful alternative to straight stock or bond investments, combining the best features of both worlds. This year, however, volatility and sector rotation have reasserted the importance of portfolio diversification. For the long?term investor, asset allocation makes the task of diversification easier. Mutual funds are investing in increasingly riskier securities to compensate for the recent stock market declines. Derivatives, foreign holdings, and restricted securities are among these riskier securities (Simon, 1994:49). Risk tolerance and asset diversification become more important when developing an investment plan based on a particular goal. Various asset allocation models-- from conservative, real estate weighted, to income growth, to capital accumulation-- can help portfolio managers adjust to changing needs (Spradley, 2000:36).

(Source: Spradley, 2000:36).

Q. 3 "Are convertibles a long-term hedge?"

The convertible bond's price floor is theoretically equal to its value as a "pure fixed income instrument". When the market is rising, the convertible increases more slowly than its common. This results in losses on the short position with the rise in equity market. The parallel but less steeply inclined, upward movement in the long convertible position may offset losses on the short position. The objective of convertible arbitrage is to generate positive cash flow while limiting risk through the use of hedges. The long position generates coupon or dividend income and creates a financing expense margin borrowing. The short position generates short interest rebate income from interest earned on the sale proceeds, and generates dividend expense. Convertible arbitrage is a demanding strategy not suitable for the individual investor unless through professional channels. An "arb" hedges typically $1,000 in a convertible, as opposed to approximately $700 in the underlying common. The target return on the investment is in the low double-digits, and employs a 50 percent margin with convertible preferreds, and higher margin with common convertible bonds (Stovall, 1993:87).

In conclusion, the safest answer to long-term hedging questions in any instance is: diversify. For the present year (2000), the bond funds that appear to be favored include long-term Treasuries and corporate bonds, convertible and otherwise. According to Roger DeBard, managing director of Hotchkins & Wiley, a Los Angeles investment firm, as the federal budget surplus increases, the Federal government will be borrowing less money, and thus it will be issuing fewer bonds. The variable in the question lies in the direction interest rates will take in the near term. DeBard also suggests not abandoning value funds. Electric utilities and financial services, two strong areas for convertible bonds, are among the "favorite" industries this year. These industries' earnings have a history of growing 13 percent a year and sell at 13 times their earnings. Also, municipal tax-exempt long-term bonds are preferable to taxable Treasury or corporate bonds (Kom, 2000:92). In this context, convertible bonds appear as a viable option, and convertible bond funds emerge as a safe middle ground for those seeking higher returns than tax-exempt bonds now offer. These prospects are contingent upon the future direction of the economy generally, and of inflation and interest rate in particular, as we have seen.

Q.4 "What can we expect predict about the economy and inflation that will have bearing on investment decisions in the future?"

This study has considered what investors can expect or predict about the state of the economy and the rate of inflation that will impact investment decisions generally, and convertible bond alternatives in particular. We have found that, regardless of investment advice, market studies, or the historical data predicting trends and outcomes, a balanced portfolio should contains hybrid stocks and bonds, long-term taxable and tax exempt securities, and equities. Convertibles enhance a fixed income portfolio as a conservative, but yield-oriented way to play the equity market, according to Larry Keele, manager of Vanguard Convertible Securities. Vanguard funds have averaged 15.6 percent over the past decade with convertibles, which Vanguard feels have an imbalance of upward potential with reduced risk. A prominent alternative to Vanguard is Fidelity Convertible Securities, which has averaged 20.5 percent a year over the past decade. Fidelity Convertible Securities, however, is a riskier fund having recently fallen under a new manager who previously ran a tech firm (Feldman, 2000:41) Historically, there are three outstanding no-load convertible funds which Value Line tracks, and which have solid yields and the ability to weather tough periods:

Vanguard Convertible Securities:
Longest history of over more than 9.5 percent total return over 10 yrs on an annualized basis.

Fund Up 12.6% (October 1996)
5 Yr. Annualized Return = 11.9%
Yield = slightly over 3%
Minimum investment = $3,000, IRA accounts$1,000

Fidelity Convertible Securities:
Fared reasonably well in 1994 losing only 1.76 percent in tough year for both stock & bond markets.

Fund Up 8.9 1 % (Pt 9 mos. 1996)
5 Yr. Annualized Return = 14.27%
Yield = 4.32%
Minimum investment = $2,500, IRA accounts = $500

Key SBSF Convertible Securities Fund:
Despite long-term showing, Key fund rough going in 1994 losing 6.4 percent that year.

Total Return = 13.54% (October 1996)
5 Yr. Annualized Return = 12.51%
Yield = 4.77%
Minimum investment = $500, IRA accounts = $250

(Source: Anderson, 1997:55)

Convertible bond funds, like all complex financial instruments and the mutual funds based on them, require constant monitoring by investors, who must have ready access to data regarding the movements of face price and underlying price of the stocks. In short, convertible bond funds are not a "low maintenance" alternative to conventional equity investment, or a substitute for prudent portfolio allocation, distributing risk among diverse instruments.

CHAPTER FIVE
CONCLUSIONS

5.1 Recommendations

Despite the uncertainty of the markets, there are some convertible bonds and bond funds, which can be recommended on the basis of past performance and asset strength. The most current data (2000) on top bond and convertible funds follows:

Table 4.
Convertible Bond Funds

5.2 International Investment Options

Many observers believe that international investing has more upside than downside than the US market has at this time. Mutual funds outside the US are of two types: 1) international funds, which contain foreign stocks only, and 2) global funds, which contain both international and US stocks (Kom, 2000:92). Yet overseas markets have fared worse in 2000 than the US market has. Morgan Stanley EAFE index fell 15 percent, which provides enticing opportunities for astute stock pickers. Japanese lender Sanyo Hinpan, for example, is typically invested heavily in European and Japanese convertible bonds. Trades have been at 70 percent of book value and have had high returns on capital and are expected to continue to expand.

Convertible bond investors looking at the international alternatives must always track inflation rates carefully. In the last year, for example, several interest rate increases by the European Central Bank in Germany had apparently halted inflation in the EU, yet inflation in the euro-region hit 2.4 percent in June 2000, the fastest rate in four years. In Japan and Brazil, troubled markets and lingering recession have led investors back into bonds. This pattern is widespread; as much as 40 percent of the global economy is still in recession. Global stock markets reflect this reality, and convertible bond funds benefit from this perception ("Country Focus... ",2000:67).

Another risk in international bonds and bond funds is fraud or deception. For example, the Julian Robert's Tiger Management is being investigated for possible insider trading on an out-of-business $6 million hedge fund in France. The Euro tunnel stock is associated with the operation of the Chunnel linking France and England; the suspected net profit currently is at approximately $176 million ("Insider Trading in Chunnel Stock?" 2000:14). Wherever trading rules limit the transparency of corporate finance, bond funds share some of the risk with the firms' equities.

Domestically, the latest set of economic data predicts the Federal Reserve will continue to hike the interest rate in the near term. Increases in demand have outpaced rapid productivity driven gains in potential supply. Interest rates have not yet risen to levels consistent with the overall tighter financial conditions needed to slow demand to a pace to let inflation pressure subside. Since June 1999 interest rate hikes have risen 179 points. This brings the federal fund rates to 6.5 percent, pushing up the cost of credit. There still is little indication of slowing down the economy.

Finally, convertible bond funds are susceptible to movements in exchange rates, labor costs, and productivity shifts. Inflation picks up whenever industries' manufacturing activities are geared up in response to stronger exports. A further acceleration in productivity growth will either create upward pressure on prices and interest rates or a downward pressure on profits. Either way, the stock market loses and convertible bond and bond funds grow in attractiveness to risk averse investors.

Since decisions to convert preferred stock equity to bond hinges in part on the stock market activity and company debt ratio, the best investment approach is probably a thorough analysis of historical data, recent government, trade, market and consumer activities, and individual accounts. Based on the findings we can determine graphically what will best suit the corporation, company or individual investor. The risk factor involved hinges on the liquidity of the available assets and the need to concentrate on conservative investment strategy. The best conclusion when analyzing data to come to an investment decision is almost always to diversify the portfolio. If the stock market slows, then convertible bond mutual funds and treasury securities are safer harbors for investments. The growth is slower but the risks are greatly reduced and the conversion feature affords a certain hedge against a renewed strengthening of the market.

5.3 Summary

Given both their inherent features and their stellar performance during the past two decades, convertible bond funds are a highly attractive means for capturing most of the upside in related common stocks with far less of the downside. In the past, the complexity of this asset class has undoubtedly deterred individual investors from considering convertible bonds as a portfolio-diversifying alternative to equities and other types of fixed-income securities. Nevertheless, retail investors can participate in the convertible bond market through the vehicle of a professionally managed mutual fund. Convertible bond mutual funds transfer the complexities of convertible bond valuation, selection and management to Rind managers, permits investors to achieve diversification within a moderateto high-risk asset class, and allows them to do so with only a modest capital outlay. Nonetheless, particularly with the entrance of smallcap, high-tech companies into the convertible bond IPO market, the risk profiles of these funds vary dramatically. Some funds hold investment grade and intermediate grade bonds that have very little price volatility, their conservative portfolios resembling those of triple B bond Rinds. At the other end of the spectrum, some convertible bond funds hold the "high-yield" or "junk" bonds of small, high-flying technology and telecommunications concerns. Their price movements resemble equities far more closely than bonds and are nearly as "risky" as the stocks of "aggressive growth" mutual funds. With these admonitions in mind, retail investors can select the risk level that is compatible with their own risk-aversion profiles and their specific investment objectives from among the range of open- and closed-ended bond funds currently available to them.

These considerations should be taken into account when analyzing data for prospective investment in convertible bonds, treasury securities, zero-coupon vehicles, or other investment tools to secure assets, to promote growth and to hedge the bet for the long-term. For those without access to high-speed current information, the alternative of convertible bond funds many be an ideal solution to the problem of finding a secure, stable investment in the coming period of post-boom financial markets.

BIBLIOGRAPHY

"A New Leader In The Bond Derby?" Business Week. April 5, 1995 (Issue 3 623), p. 123.

"A sideways move." Industry Week. (May 19,1997), Vol. 246, No. 10, p. 40.

Ablan, Jennifer. "Hedge funds crowd convertible-bond market, long-term buyers look for other alternatives." Wall Street Journal. September 29, 2000, p. C 16.

Ablan, Jennifer. "Province Healthcare Prices $125M Convertible, Yld 4 1/2%." Dow Jones Newswires. November 15, 2000.

Ablan, Jennifer. "Solectron Prices $1.5B Zero-Coupon Convert, YTM 3 1/4%." Dow Jones Newswires. November 15, 2000.

Ablan, Jennifer. "SpectraSite Prices $200M Convertible Bond, Yld 6.75%." Dow Jones Newswires. November 15, 2000.

Ablan, Jennifer, Vames, Steven and Calamba, Sheila. "Convertible sector breaks 1999 issuance record via $500 million deal from telecom firm Covad. "Wall Street Journal," September 21, 2000. P. C20.

Altman, Edward. "Measuring Bond Mortality and Performance" Journal of Finance, Vol.44 (1989),