Dented Convertibles, Too Cheap to Ignore

• ByTim Melvin, RealMoney.com Contributor
• On Friday November 28, 2008, 9:00 am EST

Another area of the market that has been hard hit by troubles in the hedge fund industry is the market for convertible securities. Convertible preferred stocks and bonds were heavily owned by the hedge fund industry. Some analysts estimate that as much as 70% of outstanding convert issues were owned by hedge funds.

Most of these funds practiced convert arbitrage, buying the bonds and selling short the underlying common stock. A falling stock market has damaged the value of these securities. The decline in value was exacerbated by the forced reduction of leverage. Many funds had leveraged up to increase returns, and when prime brokers demanded that they reduce leverage or pay higher borrowing costs, the selling pushed convertible market prices down more than 35% year to date. According to hedge fund industry analysts, hedge funds that specialize in convertibles are down more than 50% year to date.

Nick Calamos at Calamos Securities, a leader in the convertible bond markets, recently wrote a report to shareholders outlining exactly how cheap these markets are, in his firm's opinion. According to Mr. Calamos, the price of the average convertible issue is now undervalued by more than 10%. That is the steepest reading in more than 30 years, according to the report.

He also points out that during previous periods of relative undervaluation, the returns for the following two years were very strong for convertible investors. Earlier this week on RealMoney.com, Howard Simons wrote a great article on why he believes the asset class is severely undervalued and worth investigating as well.

I wrote a couple of weeks about some of the convertible issues I saw that looked interesting. For the most part, those names have a long way to go before the equity factor kicks in, but they have high yields, and the underlying companies have a good chance of surviving the current market and paying the dividends.

Names such as Key Corp., Fifth Third Bank and El Paso all have convertible issues that look attractive at current levels.

On Wednesday, as I prepared to spend the evening in the kitchen chopping and dicing in preparation for Thanksgiving, I looked over the list of mandatory convertibles to see if I saw any bargain issues. Mandatory convertibles are exactly that: They are a hybrid form of convert that combines a bond and equity call option. At some date they must be converted on the basis of the original range of share ratios. I found one worth considering.

Archer Daniels Midland processes, stores and sells a range of agricultural products, primarily grains such as soybeans and corn. It is also the largest ethanol producer in the world. On the campaign trial, our new president pledged to continue ethanol production and subsidies. He also talked a lot about spending money on alternative fuels. For the long term, this bodes well for the company. The stock is cheap, trading at 7 times earnings and near book value. It has a mandatory convert that yields over 9% and trades near conversion value. The issue must be converted by June of 2011. As I believe the stock will do well over that 30-month period, the convert is a good buy.

Convertible investing can be complicated. Pricing involves bond, equity and option pricing. There can be differing conversion ranges and ratios. Pricing in some of the bonds can be a bit opaque, and accurate quotes difficult to obtain. This can cause a lot of people to ignore this market. I believe this is a mistake. Right now, the hedge funds' pain can be our gain. The market is far too cheap from a long-term perspective.

Fortunately, there is a way to play this market. As a bonus we can take advantage of a longstanding market inefficiency to gain a significant price advantage. In the boom times, several convertible-bond closed-end funds were sold, primarily to retail investors. Since then, we have seen panic selling in the asset class and in the fund shares; these funds now trade at an enormous discount to the value of the fund holdings.

Mario Gabelli's firm has been active in the convertible markets for decades. His firm runs the Gabelli Convertible and Income Fund, which is traded on the NYSE. The fund has recovered from the lows and offers and eye-popping 17% yield. There is substantial recovery when the markets recover as well.

The Calamos firm also has several convertible closed-end funds that offer high yields and trade at a discount to the value of their holdings. They include the Convertible High Income Fund and the Convertible Opportunity Fund.

Convertibles have become so cheap that you can't afford to ignore the market for these issues. Whether you find your own favorites or allow a seasoned veteran of these markets to select the portfolio for you, long-term investors should be buying these on down days in the stock market.