mania , plus changes in accounting and other factors , led to declining issuance of convertible preferreds , although the use of convertible bonds in corporate deals continued — notably in the gigantic Kohlberg Kravis Roberts & Co . leveraged buyout of RJR Nabisco in 1988 , which included a $ 2.3 billion convertible bond as part of the $ 24.8 billion consideration paid to RJR shareholders .
Individual Investors in the Convertible Market
It was natural that convertible preferred shares were much more common in the first three decades after World War II , because individuals still dominated the stock market , and preferred shares were always much easier for individuals to trade than corporate bonds .
Early in 1969 , the broad stock market peaked ( as reflected by the Value Line 1700 index ) after a euphoric period that had seen many electronic technology startups go public and had included heavy issuance of convertibles among smaller companies , as well as large and acquisitive companies . The bear market that started with small-capitalization stocks in 1969 finally enveloped larger-capitalization stocks and even the “ Nifty Fifty ” in 1972 and bottomed in November 1974 — with a consequent reduction in the issuance of convertibles .
In the early 1970s , more than half the value of the US convertible market was still in convertible preferreds , which were largely a legacy of the merger and acquisition activity of the 1960s . Convertible preferreds typically were issued by larger companies and were of larger size than the convertible bonds of the day , some of which were only in the few tens of millions of dollars .
The transition toward institutional investing began in the 1960s . Institutional Investor magazine began publication in 1967 . The institutionally dominated era grew with the long bull market that began in late 1974 . In the late 1970s , the convertible market resumed its growth , with more issues , larger issues and growing interest among institutional investors .
Retail investor interest in mutual funds began to resume in the 1980s ( after having faded during the 1969 – 1974 bear market and its immediate aftermath ). Three noload convertible funds were launched in
1985 : two Noddings-Calamos funds ( one oriented toward growth , the other toward income ) and the Value Line Convertible Fund . More convertible funds followed , including some closed-end funds .
Hedge funds that specialize in convertible arbitrage — long convertibles while short the underlying stocks — began to appear in the 1980s . Such funds enhance liquidity in the convertible market and often provide favorable returns with low volatility .
It is especially difficult today for most individual investors to purchase convertible bonds because almost all new convertible bonds are issued as private placements under Securities and Exchange Commission ( SEC ) Rule 144A , which avoids registration requirements and confines sales at issuance ( and for six months afterwards ) to Qualified Institutional Buyers ( QIBs ). For most retail investors , it is practical to choose an exchange-traded fund ( ETF ) or a mutual fund . High-net-worth investors who have large portfolios may want to trade individual convertible bonds , and a few listed convertible preferreds remain . There are also many mandatory convertible preferreds , which are easy to trade , but typically require sophisticated quantitative analysis . These issues automatically convert into the underlying common stock after three years . Mandatory convertibles were invented in 1990 and may be the only genuinely new type of convertible .
Convertible Valuations
The few convertible models that existed prior to the 1973 publication of the nowfamous Black-Scholes-Merton ( BSM ) equation were basic . The first widely used convertible model was introduced by Value Line Convertibles in 1972 , just prior to BSM . It was an empirical model , but the relationships between derivatives ( including convertibles ) and their underlying interests that were quantified by BSM apparently were inferred by the Value Line Convertibles model , which projected the upside-downside asymmetry of individual convertibles relative to price movements of the underlying stocks . In the 1970s , Value Line Convertibles was the only source of comprehensive information and evaluations of convertible securities .
After personal computers and the Internet came into widespread use in the 1980s , sophisticated quantitative convertible models and comprehensive convertible data ultimately appeared on the desks of all convertible professionals . Value Line Convertibles was the last remaining convertible service for individual investors when it ceased publication in 2019 .
Resurgence of New Issues of Convertibles in the 1980s
The 1980s saw a resumption of convertible bond issuance by household names . The archetypical One Decision stock — IBM — floated a $ 1.25 billion convertible bond in 1985 . Other prominent companies with convertibles in the 1980s included Home Depot and Wendy ’ s .
Zero-coupon original-issue-discount ( OID ) convertibles were introduced by Merrill Lynch in 1985 as Liquid Yield Options Notes ( LYONs ). The first LYON was issued by Waste Management with a put at accreted value in just over three years , followed by annual puts . Over the next seven years , 67 LYONs were issued .
The downside protection of LYONs was superior because of the interim puts , but the appreciation potential was muted because the conversion price increased at the rate of accretion toward maturity . The issuing corporations were able to tax deduct the accretion , and taxable accounts had to pay taxes on the “ phantom ” imputed interest .
A conversion price that rose was a throwback to convertible bonds in the two decades following World War II . Poensgen observed in 1965 that “ 40 % of a sample of 165 postwar [ convertible ] bonds … [ have ] a conversion price that changes … usually in five-year intervals , invariably increasing .” Over time , issuance of zerocoupon OID convertibles ceased , but the LYONs structure left a legacy of shorter maturities of convertible bonds , and a few issues had interim puts . At the same time , issuance of convertible preferred shares — which typically had neither maturities nor puts — faded further from the public market .
In 2002 , General Motors ( GM ) floated two issues of convertible bonds totaling $ 3.3 billion that were ideal for individual investors : New York Stock Exchange – listed baby bonds that were issued at $ 25 instead of the usual $ 1,000 par .
The GM convertible bonds were often mistaken for preferred shares because they
40 FINANCIAL HISTORY | Spring 2024 | www . MoAF . org