Before joining the Gabelli organization in 1993, Mr. Woodson worked in Amsterdam, The Netherlands for ABNAMRO Bank where he was responsible for new issue activities concerning convertible bonds, preferred shares and warrants in all currencies. Prior to that he worked in New York for AMRO Bank in the Capital Markets Group and as a Credit Analyst for Meridien International Bank. Mr. Woodson graduated from Trinity College, Hartford with honors in History and International Relations. He received his Masters in International Affairs from Columbia University, New York were he was elected an International Fellow.The Best of Both Worlds

Convertible securities, (a.k.a: converts) are bonds or preferred stocks that can be exchanged (converted) into a fixed number of common stock shares of the issuing company. Convertibles combine the capital appreciation potential of equities with the higher income and safety of fixed income instruments.

The Global Convertible Securities Market

Liquidity is always an issue in evaluating different investment asset classes. The global convertible securities market is large, diverse, and liquid. To put this in perspective, with a capitalization of over $400 billion, the global convert market is bigger than the equities markets of Sweden, Australia, or Hong Kong. The Japanese convertible securities market is the largest, with capitalization of approximately $160 billion or 38% of the total global market. The U.S. is second with about 31% of the market or $130 billion. Europe is third with about 24%, and the remaining 7% comes from emerging market nations.

Europe is the fastest growing segment of the market. Companies are using converts to monetize assets in the restructuring process in a tax efficient manner. Securities being issued by parent companies or large corporate stockholders are convertible into common stock of the companies being sold or spun-off. Capital gains taxes are deferred until the convertible privilege is exercisable‹generally five years after it is issued. Examples of these converts include Swiss Life into Mannesmann, Canal Plus into Mediaset, and Pathe into B Sky B. There is substantial demand for converts in Europe as an equities culture evolves.

Reducing Risk in Increasingly Volatile Global Markets

Markets no longer act in isolation. A Russian debt default or Taiwanese earthquake will send financial tremors around the world. Increased volatility, or the extent to which prices fluctuate over time, is now a fact of life. Convertible securities reduce portfolio risk. In fact, over the last 25 years, U.S. convertibles have provided about 86% of the return of the S & P 500 with about two-thirds the risk. Convertibles have been even less risky than corporate bonds as measured by the standard deviation of their returns. (Standard deviation measures the degree to which returns may differ from the average). Moreover, convertibles demonstrate a low degree of correlation with both equities and bonds. This low degree of correlation, especially with bonds, explains why convertibles can be used to reduce volatility in a portfolio. Studies indicate that the optimal amount of convertibles in a portfolio is about 5 percent of total assets.

Benefits

There are four main benefits to investing in convertibles. First, converts offer upside potential when the stock rises. Typically, convertible investors hope to gain two-thirds of the upside of the common stock with only one-third of the downside risk. Second, convertibles pay a higher current yield than the dividend yield on the underlying stock. The average current yield in the U.S. convertible market is 4.3% versus only 1.3% on the S & P 500. Third, convertibles provide downside protection. If the stock price falls and the right to convert into the common stock becomes worthless, the convertible will trade solely on its fixed income characteristics. This price, known as the bond "floor", sets a minimum value for the convertible. Finally, they enjoy superior ranking to common stock in a companyšs capital structure.

Busted, Balanced, or Butane?

Convertible securities are generally created equal‹issued at about a 25% premium to conversion parity (the common stock for which the convert can be exchanged must appreciate 25% before the convertible bond holder can make a profit by converting into the common). However, out in the open market, converts take on very different identities. If the underlying common stock sinks appreciably, the conversion privilege loses value and, in some cases, may become almost worthless. These are called "busted" convertibles and generally provide very high yields. If the underlying common remains within hailing distance of its conversion price, the convertible issue is referred to as "balanced". These converts continue to enjoy a yield advantage over common shares and retain capital appreciation potential. If the underlying common shares soar, putting convertible shareholders "in the money", the convert will trade like the underlying common stock. We call these "butane" converts. Since a picture is worth more than a thousand words, the following chart demonstrates the attractive performance characteristics of convertible securities:

Assuming interest rates and credit spreads remain unchanged, the bond floor represents the minimum value of the convertible. If the stock price falls dramatically the conversion option will become worthless and the convert will trade just like a straight bond. Its value will hold at the bond floor even if the stock price continues to fall. The stock price line represents the value of the convert if it were converted into stock. The difference between the stock price line and the convertible price is the conversion premium. This premium is the additional amount the investor pays to own the convertible rather than just the underlying stock. The investor is willing to pay a premium in exchange for higher current income and downside protection. As the stock price falls, the convert will outperform the common stock and the premium will expand. As the stock price rises, the convert price will behave more like the equity and the premium will contract.

As the following examples illustrate, each of these three types of convertibles have different risk/reward characteristics.

Busted: Chock Full oš Nuts
Chock Full oš Nuts roasts and packs coffee, which it sells wholesale to restaurants and groceries throughout the U.S. and Canada. Each $1,000 bond paid out $80 in coupons and was convertible into 128 shares of common stock at $7.81 per share. Following the convert issue, Chock Full ošNuts stock swooned due to the companyšs poor strategic planning. In March 1999, the common stock traded at just $5 per share while the converts traded at $995 and yielded 8%. However, the fundamentals of the business were sound, cash flow was good, and the brand name was attractive. We saw an opportunity. We felt the convertšs coupon was secure and that itšs 8% yield was quite attractive. We also believed the common stock was worth considerably more than its depressed price. Sara Lee Corporation agreed with us and acquired Chock Full for $11 per share in June 1999. This busted convert got unbusted in a hurry‹soaring to $1,330 for a 34% gain.

Balanced: Vivendi
Vivendi is a Paris based conglomerate with three main business segments: utilities, communications, and construction. With operations in about 90 countries and sales of over $32 billion, Vivendi provides water services to 80 million customers worldwide. In France, Vivendi has interests in telecom, pay-TV, the Internet, and media. Following its purchase of Francešs largest film producer, Pathe, it will also have a significant stake in UK pay-TV operator BskyB. At 65 Euros per share the stock is attractive on a sum of the parts analysis which values the company at over 90 Euros. Vivendišs 1.5% convertible due 2005 was launched April 1999 to help finance its purchase of US Filter. Currently, the bond trades on a 27% premium and 1.6% current yield. Given a plus or minus 25% change in the stock price over the next year, we estimate the bond will participate in about 50% of any upside movement with less than 10% of the downside risk.

Butane: Telefonica
When the price of a stock rises, there is no limit to how high the price of the convertible can go. A convertible with a price of 200% of par will trade one for one with the underlying stock. Although such convertibles have lost all of their downside protection, their higher yield may still offer an attractive alternative to the stock. An example would be the convertible securities of Telefonica, the Spanish based telecom conglomerate, which have been marching lockstep with the stock and provide a 1.25% current yield versus nil on the common stock. Deep in-the-money convertibles can be blended into a convertible portfolio to produce the desired level of equity sensitivity for each individual investor.

At Gabelli, we have been managing convertible portfolios for over 20 years. Convertible securities provide a natural overlay for value investors. With converts you earn current income while you wait for a catalyst to unlock hidden value. In other words, you get "paid to wait". In their book, Security Analysis, Graham and Dodd referred to convertibles as "... the most attractive of all (securities) in point of form, since they permit the combination of maximum safety with the chance of unlimited appreciation in value". We agree. Convertible investing is a win, win proposition.

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