Convertible Bonds Proving Better Value in Bear Market

Wall Street West

by Benjamin Mark Cole

It was a long time coming, but investors in convertible bonds are finally being rewarded at least in a relative sense for taking stakes in bonds that pay interest, but which are also exchangeable for stock, under certain conditions.

From 1975 to 1995, so-called converts held their own as an investment choice against the S & P; 500 Index a broad gauge of blue chip stocks but faded for the next five years. In the bear market, however, converts have caught up as the interest payments they contain protected their value.

An investor putting $100 into either stocks or converts in 1975 would have received $1,300 by 1995, according to Los Angeles-based Froley Revy Investment Co., one of the nation’s leading convertible bond money management shops.

The next five years were beautiful for straight stock investors. That $100 from 1975 grew to more than $5,000 by 2000. Meanwhile, total returns on converts rose more modestly, to less than $4,000, based upon the Froley Revy Convertible Bond Index.

But in the last couple of years, the S & P; total fell back to $3,500. Converts, whose values tend to track stock prices if they’re near their conversion price but will otherwise trade more like bonds, fell much less. The original $100 in 1975 is worth about $3,500 in converts as well.

According to efficient market theory, it’s nearly impossible to outperform securities markets over time, whether it’s with one class of assets or many. Nearly all investment styles or tactics appear to “regress to the norm,” or overall market return averages.

That said, there are pitfalls a-plenty for investors, largely due to accounting issues. What especially worries bond investors is pension obligations, according to George Froley, chairman who founded Froley Revy in 1975.

“General Motors has pension obligations to current and future retirees that are roughly three times the company’s market cap,” said Froley research analyst David Epstein in a recent newsletter. If the stock market goes sideways, these pension obligations become harder to fulfill.

No Conflicts?

While the heat is on hired accounting firms and outside (non-management) company directors to not have conflicts of interest that might taint their judgment, lawyers have largely dodged any legislative or regulatory bullets.

A generation ago, it was considered bad practice in the legal industry, though not illegal, for a lawyer or law firm to take equity in a client. The concern was that a lawyer might render advice thinking about his or her stock value, and not law or ethics.

Beginning in the 1980s, more firms were willing to take equity, and the practice became widespread. Now, many lawyers are licking their wounds. “Many of those law firms, especially in the Silicon Valley, are sorry they did (take equity),” said Robert “Rob” Steinberg, partner and securities law expert with Century City-based Jeffer Mangels Butler & Marmaro LLP.

“The issue is sort of dead now, as law firms are very reluctant anymore to take equity in clients. We in general have always had a policy against it,” Steinberg said.

Still, it’s notable that among the many possible reforms being tossed about, barring lawyers from taking equity in clients hasn’t been even mentioned.

QQQuick Buck?

For stout-hearted investors bullish on tech stocks, John Marrone, managing director of Roth Capital Partners in Los Angeles, has a play: buy a long-term option on QQQ, the stock that tracks the Nasdaq 100, the 100 biggest stocks trading on Nasdaq.

As of last week, QQQ traded in the $23 a share range. For $1 a share, investors can buy an option, providing the right to buy QQQ for $35 a share in two years, Marrone noted.

Nasdaq stocks have been particularly hammered in the bear market. The Nasdaq composite is off roughly three-quarters from highs above 5,000 back in early 2000, to a recent level of about 1,300.

Should the Nasdaq go back to 3,000 within the next two years, then investors in QQQ options would see handsome profits on the order of nine-to-one returns, before transaction costs. Investors also have the right to sell their options anywhere along the way.

Of course, it’s a high-risk play. The Nasdaq may rally, but would have to leap by more than 50 percent for QQQ options investors to merely break even.

And Marrone notes that profits on options trades are taxed as ordinary income, not the lower long-term capital gains rate.

Still, the thought is tempting, said Marrone. “You know, the two-year QQQ option sold for $115, back in March of 2000,” he said.

Sidelined

Attorneys Michael Abbott and Kevin Fitzpatrick of Los Angeles-based Jones Bell Abbott Fleming & Fitzgerald usually keep a busy schedule handling securities arbitration cases.

But like all other arbitration lawyers in California, they have been sidelined of late, awaiting the outcome of a showdown between the state legislature and the two groups that run the nation’s biggest stock markets the National Association of Securities Dealers and the New York Stock Exchange.

California wants recently strengthened conflict-of-interest laws to apply to securities arbitrators; the industry groups do not. Cases are at a standstill in California, and recently SEC Chairman Harvey Pitt intervened to tell the NASD and NYSE to comply with California law.

As of last week, they hadn’t held any arbitration proceedings since the California law took effect on July 1. Abbott and Fitzpatrick, who typically represent brokers, don’t want different rules in each state. “There should one be one set of rules that apply to the arbitration process,” Abbott said. “That makes the most sense logically and procedurally.”

Glendale-based Public Storage Inc., the REIT that manages nearly 1,400 rental locations, recently proved it is possible to raise money on Wall Street, even $150 million, but you have to pay for it. Recently, Public Storage sold $150 million of preferred stock through lead manager Salomon Smith Barney Inc., yielding 7.5 percent in dividends. Standard & Poor’s rated the issue BBB+, which is still considered investment grade, but containing significant risk during certain economic cycles.

Contributing columnist Benjamin Mark Cole writes about the local investment community. He can be reached at

[email protected].