How high canstocks go? Since breaking through a record closing
high on March 5, the Dow Jones industrial average has continued
to post fresh highs. The broader S&P 500index has more
recently done the same.
Those were heady times back in October 2007 when both the Dow
and S&P 500 closed at all-time highs.
But what happened only two short months later is still fresh
in our collective memory. The GreatRecession officially began in
Nine months after that, in September 2008, Lehman Brothers
declaredbankruptcy , and lending seized up around the globe.
Investors panicked,stock prices plummeted, and by March 9,
2009, the Dow and S&P 500 had lost more than 50% each.
We're not likely to see acorrection of this magnitude again.
This time around, the U.S.economy is improving and companies are
awash incash . Stocks are still reasonably valued, with the
S&P 500 carrying a forwardP/E (price-to-earning) ratio of 14,
based on estimatedearnings of $112.50, only slightly above the
five-year average of 12.9, according to FactSet.
But the big push behind stock prices is the Federal Reserve's
low interest rate policy, which encourages corporations tofund
growth and investors to take risks in search of higher yields.
When the proverbial "punch bowl" of Fed cash flowing around the
economy eventually gets taken away, stock prices could
Stocks aren't the only assets thatwill be affected when
interest rates start to rise asmonetary policy tightens.
Right now,corporate bond prices are at record levels as
investors chase higher yields. And as themoney has moved in,bond
yields (which move inversely to prices) have been driven down to
record lows. Evenjunk bond yields have dropped below 5%, a far
cry from the 22.7% peak in 2008, according to Bank of America
Merrill Lynch data.
As interest rates go up, bond prices will go down in order to
bring theyield on existingbonds in line with the higher yields on
new bonds. Ifthe Fed 's easy-money policy spursinflation ,
thefixed-income payments could also lose value. At the same time,
withunemployment rates still above where the Fed would like them,
a low-interest environment may stay a while longer -- meaning you
could continue to enjoy the steady, predictable payments that
bonds andpreferred shares provide for some time without getting
Put simply, both stock and bond investors face plenty of
future uncertainty, but also reasons for optimism.
So which makes a betterinvestment right now -- stocks
Stocks could keep moving up, but they could also be ripe for a
correction. Bonds provide steadyincome , but the bondmarket could
burst if rates were to suddenly move higher.
Luckily, you don't have to make this either/or
Say hello to convertible preferred shares, or "convertibles."
They are the perfect security for an uncertain market. They
provide the reliable income of bonds but track theupside of
stocks through a conversion feature.
What you need to ask when hunting for the best convertibles
are two key questions: What's the
or discount? And what's the
The conversion premium is the difference between the
conversion value of the convertible and its current price.
Typically, convertibles sell at a premium because they provide
higher payouts than thecommon stock . But the lower the premium,
The payback period is the time it takes to recoup the
conversion premium and break even on your investment in the
convertibles compared with simply buying the common stock. Again,
the shorter the better.
When I search for convertibles, I look for a short payback
period (of less than five years). I also look for acurrent yield
of at least 4.5% and acall date at least two years out so as to
provide time to enjoy the superior income and allow the
commonshares to rise before converting.
As a final measure of quality, I make sure that the underlying
common stock had a positive price trend at least over the past
six months, to make the conversion feature more attractive.
These are stringent criteria in today's euphoric markets, but
in a pastissue of
I did manage to find half a dozen convertibles worthy of further
One that I found particularly interesting is the convertible
, which is a top-10 U.S. builder of single- and multi-family
I did a complete analysis of
Beazer Homes 7.50% (
convertibleissues in the January 2013 issue of my
newsletter. In the nearly six months since I showcased them, the
price has gained a healthy 33%, all while throwing off yields
well above 7% for those who purchased them in January.
Even if you didn't invest back then, at a recent price of
$34.45, the Beazer convertibles pay a $1.875 annual distribution,
which still gives them a current yield of 5.4%.
By comparison, Beazer's common stock doesn't pay a dime in
Action to Take -->
One thing to remember is that the conversion feature on these
securities could be worthless if the common shares lose value.
Still, unless the company runs into trouble, interest payments
andgains on the convertibles should continue to provide solid
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