Internet convertibles performed like BMW convertibles during the first half of 1999, zooming ahead 45%.
That's not supposed to happen in the investment world, where convertibles are supposed to be safe and conservative, not racy.
Institutional managers that resisted the allure of the Internet convertibles were left behind in the performance race during the period, as, according to Merrill Lynch & Co., New York, non-Internet convertibles returned only 12.51%.
"Our efforts to use convertibles are inherently incompatible with buying convertible bonds with little creditworthiness," said F. Barry Nelson, senior vice president and portfolio co-manager at Advent Capital Management, New York, which has $240 million in convertibles.
Staying at speed
But the Internet convertible market is not expected to slow down anytime soon.
Internet giants such as America Online Inc., Amazon.com Inc. and Exodus Communications Inc. all have come to market with convertibles this year, expecting the excitement over their stocks to spill over into the convertibles market.
Convertibles are attractive because they often carry a good potential for upside gains if the investor chooses to convert his options into stock, but they are protected on the downside in that the investor will get a fixed rate of return, unless there is a credit default. According to managers, defaults are more common with high-yield bonds than with convertibles, making convertibles a safer investment in terms of credit risk.
Advent's Mr. Nelson followed the traditional low volatility and risk-averse strategy in convertibles. Others did not, and they continue to see opportunity in the Internet convert area.
They expect the market for Internet convertibles to continue growing as long as the underlying stock continues to soar.
For Internet companies, the decision to issue a convertible is an easy one, money managers said.
Convertible bonds are the perfect way to raise money because investors (mainly hedge fund managers) are willing to pay for high volatility, and that high volatility in return actually lowers the cost of issuing paper, said Nick Calamos, managing director and portfolio manager at Calamos Asset Management Inc., Naperville, Ill.
Lately it has seemed the higher volatility of the stock, especially in the Internet sector, is triggering the higher demand. According to Mr. Calamos, people are willing to pay more for the paper -- making it less expensive to issue -- because they are expecting to sell short. Issuing a convertible is also non-dilutive to the stock price, because essentially a convertible is a bond with an equity option component.
Also issuing a convertible is cheaper because the interest rates are sometimes half those of traditional bond offerings, he added.
From Jan. 29 to June 4, Mr. Calamos has seen at least nine Internet convertible offerings: Amazon.com; Exodus Communications; CNET Inc.; DoubleClick Inc.; Sportsline USA Inc.; Tribune/AOL; MindSpring Enterprises Inc.; PSINet Inc.; and [email protected] Inc.
About 1.5% of Calamos' $4 billion convertible portfolio is in Internet names. While Mr. Calamos took his profits from DoubleClick and Exodus months ago, he is now invested in PSINet, MindSpring and [email protected] Noting he is underweighted to the index, Mr. Calamos says he is, and will remain, "very, very selective."
The Calamos U.S. Convertible Composite returned 11.25% for the year-to-date as of June 30, while the benchmark of the First Boston Convertible Securities index finished at 11.72%.
Mr. Calamos is quick to point out he has "one foot out the door" on some Internet convertibles, waiting and hoping for mergers or acquisitions. "If they don't get acquired they won't make it," he said.
Kathleen Gaffney, vice president and portfolio manager at Loomis, Sayles & Co., is waiting to pick up the companies that don't make it.
Loomis invests $1.8 billion in busted convertibles, which are the convertibles of companies whose stock prices have fallen low enough to make the conversion feature worthless. Ms. Gaffney makes her gains by buying companies that either show potential for the stock price to move up again in the near term, thus making the equity option attractive again, or for which she expects the bond itself to become more attractive.
She expects some Internet companies to fall into this category, but the question is when.
Ms. Gaffney predicts that when any one of the companies stumbles, the market will thin out. She's sure that day will come given the conditions under which the convertibles were issued.
"The Amazon deal came on the same day Greenspan was talking about pockets of speculation bubbles," the Boston-based portfolio manager said.
At Conseco Capital Management Inc., Andrew S. Chow plans to be selective in picking his Internet convertibles. He is underweighted in the sector now relative to his benchmark, the Merrill Lynch Convertible Securities index. One major reason he is underweighted is that about 3% of the index is in AOL. "We do like certain companies, but personally I think AOL is overvalued," he said.
"We think there are a lot easier ways to make money," he said.
Mr. Chow, vice president and portfolio manager for the $40 million Conseco Convertible Securities Fund, is placing his bets on "facilitating technology," which tends to have cheaper valuations.
He looks at companies that will remain if Internet commerce sinks. Some of the convertibles he has bought using this strategy are Cisco Systems Inc. and ANTEC Corp., which have technologies that support the Internet but also can be used in other businesses.
Overall, his 16.69% return for the first six months of the year beat that of his benchmark, 13.24%.
He expects he will have more to choose from as issues in the Internet and technology sector continue to grow along with use of the Internet for business and commerce.
Investing in Internet and technology convertibles often forces managers into the role of venture capitalist, according to Ravi Malik, portfolio manager at Froley, Revy Investment Co., Los Angeles.
As a venture capitalist would, Mr. Malik reviews the business plans and fundamentals of these small-cap companies in hopes of capturing value down the line.
He is now anticipating two more Internet convertibles to hit the market, Priceline.com Inc. and Ameritrade Holding Corp.
"If the market keeps acting well, we will see an active stream of issues," Mr. Malik said.
"Convertibles have always been the choice of companies growing rapidly."