A riskier breed of convertible securities is taking the market by storm - so much so that some market veterans are predicting the death of traditional convertible bonds.
These mandatory conversion securities - known by such acronyms as DEC, ACE, PRIDE, SAIL and STRYPE - are testament to the new prominence of the more than 300 growth and income mutual funds.
Deaf to the protests of convertible managers, Wall Street is structuring these securities to fit the needs of growth and income managers, which, with $382 billion, represent 38% of stock mutual fund assets.
Investors in DECs and DEC-like securities forgo the first 5% to 25% of capital appreciation in the underlying stock, and retain 80% to 95% of the gains thereafter. In return, they receive increased current income averaging about 6%, according to Parallax Group Inc., a Stamford, Conn., research firm.
At original issue, buying such securities is analogous to buying the underlying common stock, selling away all of the upside and repurchasing some of the upside subsequently. At a set date - usually within two to four years of issue - the securities must be converted into the underlying common stock. DECs have a much lower conversion premium than convertible bonds.
DEC-type security issuance totaled $2.3 billion for the year to date through Oct. 10, according to Forum Capital Markets, a Greenwich, Conn., research firm. Issuance of traditional convertibles totaled only $9.2 billion, including a recent Mitsubishi Bank deal of $2.3 billion.
"Convertible managers were very panicky that perhaps the convertibles universe was disappearing," said Kendrick Wakeman, managing director at Forum. "They are trying to put together some sort of campaign to get more convertibles and fewer DECs issued. They are not meeting with much success."
Growth and income funds are devouring these new convertibles.
"We love 'em.....We use an awful lot of them," said Christopher Wiles, vice president and portfolio manager of $2.1 billion in equity income and utilities funds for Federated Investors, Pittsburgh.
Issuers love them too. Unlike convertible bonds, the securities are treated as equity on a corporation's balance sheet because of the mandatory conversion feature. If the underlying common stock goes up, the investor only gets 85% to 90% of the upside and the company only pays an enhanced dividend yield for a short period of time.
DECs and the other new breed of convertibles may be issued by companies directly, using their own common stock as the underlying asset, or by underwriters using another company's stock as the underlying asset.
"This family of products will continue to gobble up old-time convertible debt and convertible preferred," said Lee Cole, managing director in convertible origination at Merrill Lynch & Co., New York.
Eventually, Mr. Cole predicts, virtually the entire market will be mandatory convertible securities with tax-deductibility to issuers. Traditional convertibles will be relegated mainly to the 144(a) market, because that quasi-private market cannot accept equity securities, only debt and preferred stock, he said.
Echoed Gregg Groechel, analyst for convertibles and equity derivatives at American Express Financial Advisors, manager of the IDS Mutual Funds and IDS Advisory Inc., Minneapolis:
"We're going to start to see a lot more of them, especially with a flat tax or a tax structure where dividend income and capital gains are taxed at the same rate."
Also, DEC-type securities are far less dilutive to a company's capital structure than common stock.
"A company's crazy now to issue anything but a DEC, as opposed to common stock, unless you think your stock will go down," Mr. Groechel said. IDS has more than $1 billion in convertibles including DEC-type securities Alco Standard Corp. and MFS Communications.
"We're in a market environment where they could overtake traditional convertibles," he said.
But a bear market could bring the plain-vanilla market back to life, he conceded.
"These securities are not going to hold up well in a bear market because of their equity-like features. One, liquidity is poor; two, it has twice the volatility on the downside of a convertible bond," said Neil Feinberg, director and co-portfolio manager of $500 million in convertible investments for MacKay-Shields, New York.
What's more, in the year to date, these mandatory conversion securities have gone up about as much as convertibles. "If they haven't performed spectacularly well vs. convertibles in a bull market, the chances of outperforming in a bear market are minimal," Mr. Feinberg said, especially because DECs and their kin participate in 90% of the upside of the common stock vs. 65% for convertible bonds.
Convertible securities actually have outperformed DECs so far this year. Convertibles gained 22.34% for the year to date through Sept. 30, according to the Salomon Brothers Convertible Securities Index. DECs gained 21.18% during the same period. Convertibles, which have longer maturities, had the double benefit of the stock market's gain and the decline in interest rates, while DECs are less interest rate sensitive, said Anand Iyer, director of global convertible products analysis at Salomon and the inventor of the DEC.
"Maybe these securities are not as cheap as they claim," said Mr. Feinberg.
But growth and income managers don't believe DECs are stacked against them.
"Sometimes you're better off owning the DECs than the common. It's more complicated so it will be undervalued vs. the common," Federated's Mr. Wiles said, noting sometimes the common stock might even underperform the DEC.
Among his DEC-type holdings are Reynolds Metals Co., James River Corp. of Virginia and Westinghouse Electric Corp.
"They allow us to garner above-average income without the interest-rate sensitivity of a classic convertible bond. We'd rather have equity sensitivity than be tied to the bond market," Mr. Wiles said.
Many portfolio managers don't expect DEC-type securities to overtake plain-vanilla convertibles, even though issuers can't seem to resist them. "It will be up to the investors to say no to these securities and put a stop to it," Mr. Feinberg said.
"In a very strong equity market, issuers are able to get away with things," said Nick Calamos, director of research at Calamos Asset Management, Naperville, Ill., which runs $1.4 billion in convertibles.
But the power again will shift back to institutions. "These things only have a three-year life. In an illiquid market, why would you want to buy them?" Mr. Calamos said.
Convertibles managers say it was predicted in 1991 that preferred equity redemption common stock would kill the traditional convertibles market, but issuance of PERCs has fizzled recently.
PERCs, like DECs, have a mandatory conversion date, when they must convert into the underlying common stock. But PERCs participate in all of the common stock appreciation from the initial public offering price up to and including their cap price. With both types of securities, investors participate fully in the downside of the stock.
Not all growth and income managers like mandatory convertibles.
David L. King is co-portfolio manager of the $13.2 billion Putnam Fund for Growth and Income. DECs and the like represent less than 1% of the Putnam Fund for Growth and Income. "Superficially they look like an ideal solution for growth and income funds: keeping the yield high enough to be meaningful to shareholders. But the mandatory conversion feature means they are clearly inferior to a convertible bond, which has a coupon that doesn't go away, and inferior to convertible preferreds" where the dividend is constant over the life of the security, Mr. King said.
Mr. Groechel, a fan of DECs, acknowledges one worry. "My No. 1 concern is liquidity," especially with DECs issued by Wall Street firms rather than corporations directly. Such issues "tend to be fairly small and are not priced attractively because the Wall Street firm has to hedge its exposure."