Create Your Own Convertible

I don’t mean building a car – see this guy to do that. I’m referring to a bond that can be converted into stock.

Convertibles are hybrid securities with the features of both stocks and bonds. They usually have lower yields than regular bonds, but an owner receives the right to convert the bond to common stock at an agreed upon price. So, convert owners can receive guaranteed interest payments and still benefit from growth in a company’s stock.

While the market for converts in the U.S. is very liquid, not all companies issue them. Fortunately, you can create your own. You can also think of building your own convertible as a way to create a dividend from a stock that doesn’t pay one. So if building an annuity is not your thing, but you’d like to dip a defensive toe into the stock market, here’s another low fee option.

You can create a “synthetic convertible” by combining interest bearing securities and call options. LEAPS in particular can enable you to benefit handsomely from mispriced assets – if you have a long-enough time horizon.

“90/10” is one way to build a synthetic convert. That means 10% of the cash you want to invest goes into call options and 90% goes into an interest bearing security, such as a CD, that is held until the options expire.

The options provide built-in leverage and give you the right to buy shares in the company – just like a real convert. The CD limits your downside risk, meaning your loss exposure is limited to the amount of the call premium less the interest you earn on the CD.

That’s all there is to it. A guaranteed return plus the chance for an equity kicker. Now you can impress folks down at the dock. Plus, with an attitude and $20,000 you can go start your own hedge fund.

Morningstar has a good free guide to options for beginners here. There’s more on converts here, too.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.
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