From an investor’s perspective, review any historical returns on convertible sec

Question

From an investor’s perspective, review any historical returns on convertible securities and compare these returns to other investment products.

Review the relative volatility of the returns of convertible securities. What do the returns and volatility tell you about investing in convertible securities?

Are there certain market conditions that favor investing in convertible securities? Are there certain market conditions that investors should avoid when investing in convertible securities?

Please be more specific

Explanation / Answer

Convertible securities are basically of two types - (1) bonds which can be converted into common stock (2) Preferred shares which can be converted into Common stock. Incase of bonds the invester earns an interest and in case of preferred stock he earns a dividend till they are converted into common stock.

The historical data of Bank of America Merrill Lynch All Convertibles Index (VXA0) shows it has outperformed its underlying shares for the 1, 10 and 15 year periods ending 3/31/2016 and outperformed the S&P 500 for the 15 year period ending 3/31/2016 with significantly lower volatility across all comparative periods. Thus it can be safely concluded that a portfolio of convertible securities can provide a total return over a full market cycle comparable to the return provided by equities, but with less volatility and higher current income. In the cited comparision made by Merrill Lynch not only have their absolute returns been higher than that of their underlying stock returns, but also their risk adjusted returns have been substantially higher than equity valuation models such as the Capital Asset Pricing Model (CAPM) would imply. The unique convertible structure offers much of the best of both the fixed income and equity worlds, although it is often overlooked by investors.

While companies float such instruments for investors who are speculative investors , of late there are many stable good companies who are taking this route to generate finance. This conversion is a a very powerful tool in the hands of the investor and it becomes that easier for the company to quickly and easily generate fund from the market. When the underlying asset is selling at a price higher than the conversion price , it is wise to invest in convertibles. By this the investors has better prospect of capital gain.

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