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SmartMoney.com - Sturm's Screens
Free Stock Options
By Paul Sturm

Well, not quite. But they're virtually free — when you buy ``busted'' convertible bonds.

THIS MONTH I'm writing about some of Wall Street's oddest investments. They aren't stocks, and they aren't bonds. But they may be just right for today's difficult environment.

I'm talking about convertibles, hybrid securities that combine a portion of the upside of stocks with the downside protection of bonds. And you get a satisfying yield besides. As the old-timers say, you get paid to wait. I like that bargain these days, when annual returns in single digits once again look respectable.

What gets me particularly excited are so-called busted convertibles, the bottom shelf of the market. Last year's slumping stock prices and rising interest rates — particularly rates on junk bonds — produced a record number of these fallen issues. So I see the potential for a double whammy. Convertibles will do well if the stock market rises or if interest rates fall. And if I'm wrong? Well, yields will still average close to 10%.

Now the fine print: Even though this might be a good time to invest in them, convertibles aren't for everyone. They're complicated and can be difficult to buy and sell. Busted convertibles, in particular, are risky — though safer than owning stock in the companies that issued them. On the plus side, there's a nifty Web site called ConvertBond.com (owned by Morgan Stanley Dean Witter (NYSE:MWD - news)) where you can track them. And if you enjoy numbers-oriented challenges such as shopping for a long-distance plan, these two-part securities can become addictive.

When you buy a convertible, you get semiannual interest payments and a legal claim on assets — just as a bondholder would. But the issuing company pays a reduced interest rate because it throws in a sweetener: You also get the right to ``convert'' your loan into a fixed number of common shares. Think of this as owning two securities: a bond and an option. When the company's shares sell for close to their conversion value, the convertible moves up and down just like a stock. But as share prices get further below conversion value, the convertible behaves more like a bond and trades based on its yield and credit rating.

There are only about 700 convertibles outstanding, worth a total of perhaps $185 billion — less than the market value of Microsoft (NASDAQ:MSFT - news) or Intel (NASDAQ:INTC - news). Companies that issue convertibles tend to be young, with high hopes and few conventional assets: lots of biotech, Internet and telecom. (In contrast, companies that use junk bonds tend to be old and troubled, with conventional assets of dubious value.) Frequently, issuing convertibles is a way to cash in on high stock prices without the negative publicity of an equity offering.

Drive Home in a Convertible

These eight issues are down but not out.

Few people on Wall Street bother with down-and-out convertibles. But one man who does is Joseph Montemayor at Bear Stearns. He considers anything with a conversion premium above 45% busted, and that universe now includes around 300 issues, a near-record. Montemayor particularly likes busted convertibles with premiums that aren't much higher than 100%. They're priced like bonds but still have the potential for an equity kick.

I used ideas from Montemayor and Anand Iyer, head of global convertible research at Morgan Stanley, to create the accompanying table. Amazon isn't on my list. It's top-heavy with debt and too risky for me. Instead, consider the companies on my roster with the highest credit ratings: Clear Channel (NYSE:CCU - news; depressed because ad spending won't match last year's records), HealthSouth (NYSE:HRC - news; well-run, raising prices and reducing debt) and Kerr-McGee (NYSE:KMG - news; with one billion barrels of reserves, a neat energy play). They all offer relatively secure 7% or better yields to maturity, plus potential for handsome stock market gains.

The rest of my picks are more speculative — with appropriately higher yields. Three are fallen tech stars, where the safety of owning a convertible instead of common stock makes particular sense. Adaptec (NASDAQ:ADPT - news) has been clobbered because its franchise (a PC interface) is maturing. But the company has new products, little debt and a fat R&D budget. Ditto Conexant (NASDAQ:CNXT - news), which fell with other chip stocks. Fortunately, it has an unusually broad customer base (PCs, network access, wireless), which minimizes downside risk. Efficient Networks (NASDAQ:EFNT - news), meanwhile, boasts nearly one-third of the market for DSL modems. Yes, its shares must soar to boost convertible prices. But a 10% yield makes the wait almost pleasant.

My final two selections are poles apart. Level 3 (NASDAQ:LVLT - news), with plans for a vast fiber-optic network, is cheap today because skeptics worry about overbuilding. Still, revenue is growing, and there's no cash crunch. If Web use picks up because of new audio or video features, it has a bright future. Then there's Tower (NYSE:TWR - news). It bends metal for auto makers and is confronting a period of weak demand — in addition to taking a special hit when Ford cut Explorer production. But the company has lots of customers, a large order book and isn't likely to disappear. Buy these converts, hold them until maturity in 2004, and your annual return will be nearly 16%.

Unfortunately, few convertibles (none in my table) are listed on an exchange. You must use a broker, and spreads can be 5%. Expect a five- or 10-bond minimum. To avoid getting hosed, I suggest you shop around and monitor current prices on ConvertBond.com ($10 a month, with generous free trials).

If you'd prefer a mutual fund, I have two favorites: Bancroft Convertible (AMEX:BCV - news) and Ellsworth Convertible Growth and Income (AMEX:ECF - news). These are small, virtually identical closed-end portfolios run by an experienced brother-sister management team. Annual expenses aren't outrageous (1.1%), performance is solid (10-year annual returns north of 15%) and volatility is low. Check the company's Web site and buy the fund trading at the fattest discount to the value of its assets.

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