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Convertibles Offer Bond-Like Yields, Stock-Like Potential

Historically, the stock market has offered excellent long-term returns to investors. The historic record, though, may offer scant consolation when stocks skid by 5%, 10%, or even more. Wary investors can turn to bonds or cash equivalents, but yields are depressingly low now.

One possible solution is to invest in convertible securities. Converts, as they're known, may be issued as corporate bonds or shares of preferred stock. Either way, they generally pay a fixed yield that is comparable to bond market payouts.

Moreover, as the name indicates, these securities can be converted to common shares, which have the potential to deliver outstanding returns. Advocates claim that convertibles have 75% of the stock market's upside potential but only 50% of the market's exposure to bear market losses. When stocks head south, the relatively high yields offered by convertibles may keep some investors from selling and thus support trading prices.

History lesson
Does the record support this favorable upside-downside outlook? Judging by the last two bear markets in stocks, the results have been mixed. Convertibles held up well in the stock market crash of 2000– 2002, after the technology bubble collapsed. However, they provided little help in the financial crisis of late 2008 and early 2009.

From 2000–2002, the broad U.S. stock market, as measured by the S&P 500 Index, lost 9%, 12%, and 22% in successive calendar years. Mutual funds holding convertibles actually gained 2.5% on average in 2000, according to Morningstar. These funds lost less than 7% in 2001 and less than 8% in 2002, far outperforming stocks in those years as well. (You can invest in individual convertible issues, but they can be difficult to evaluate. Accordingly, many investors prefer the diversification and professional management of mutual funds.)

Convertibles funds delivered solid gains throughout the bull market of 2003–2007. In 2008, however, the average convertibles fund lost more than 33%, nearly matching the 37% loss of the broad U.S. stock market. During the worst of the financial crisis, converts provided little shelter.

Affected by arbitrage
Many observers believe that convertibles' poor record in the last bear market was an aberration. In the years immediately preceding the meltdown, hedge funds invested billions of dollars in convertible arbitrage. That is, these funds would buy the convertible and sell short the underlying common stock, hoping to make money if the convert outperformed the stock. Hedge funds often borrowed money to buy more converts and increase their profit potential.

When the financial crisis emerged in late 2008, banks called in their loans, some investors bailed out of hedge funds, and hedge funds had to sell their converts to raise the cash they needed. This increased selling contributed to the poor performance of convertibles in 2008.

After the deluge
Since the debacle of 2008, convertibles funds have posted strong years in 2009 and 2010. As of this writing, these funds are showing substantial returns for 2011 as well. Apparently, hedge funds have pulled back from convertible arbitrage and the converts market has generally returned to normalcy. Convertibles funds now yield 2.8% on average, far higher than the 0.5% average yield of domestic stock funds and nearly as high as the 3.3% average yield of general bond funds. Consequently, investors can get current cash flow that's comparable to the interest from bonds while waiting for the long-term results that stocks might provide.

Therefore, you might want to include convertibles in a diversified portfolio. Converts have risks and are not for everyone, but some investors may appreciate the combination of significant yield and potential stock market gains.

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A SIMPLE Solution for Company Retirement Plans

Business owners who wish to sponsor a retirement plan have many options from which to choose. The choices include 401(k), profit sharing, defined benefit, and simplified employee pension (SEP) plans. In some situations, yet another arrangement might work best: a SIMPLE (savings incentive match plan for employees) individual retirement account (IRA).

Keeping it simple
SIMPLE IRAs offer several benefits:

The catch? The maximum SIMPLE IRA contributions are modest as well. In 2011, total contributions to any individual's account cannot exceed $28,000, as explained later in this article. Other types of employer-sponsored retirement permit total contributions to reach six figures in some situations.

Strictly for small companies
To establish a SIMPLE IRA, your company must have 100 or fewer employees. An employee, for this purpose, is someone who earned at least $5,000 in compensation during any two preceding years and is reasonably expected to earn at least $5,000 in compensation during the current calendar year. Also, your company can't have a SIMPLE plan if it already has a qualified retirement plan.

If your company qualifies, it can use IRS Form 5304-SIMPLE or Form 5305-SIMPLE to create the plan. The company also must set up an IRA account for each employee. The only other requirement is annual notification. You can fulfill this obligation by sending each employee a copy of the Form 5304-SIMPLE or Form 5305-SIMPLE your company used to set up the plan.

Once the plan is in place, each employee can defer as much as 100% of his or her annual pay, up to specified annual limits. In 2011, the cap is $11,500, plus a “catch up” contribution up to $2,500 for SIMPLE IRA participants who are over age 50 by year end. Thus, the maximum salary deferral is $14,000 in 2011.

In addition, the company can choose to match employee contributions, up to 3% of the employee's compensation for the calendar year. Compared to the complex rules that apply to 401(k) plans, the rules for SIMPLE plans are, well, simple. If an employer chooses to match contributions, the matches are required for all employees, so business owners and key employees can maximize their contributions even if other employees contribute little or nothing. For example, a 50+ business owner whose pay is at least $466,667 can get the maximum $14,000 match (3% of $466,667) and put a total of $28,000 into his or her SIMPLE IRA this year.

As an alternative to making matching contributions, the employer can choose to make nonelective contributions of 2% of the income of each eligible employee that earns $5,000 (or a lesser amount if the employer selects) of compensation for the calendar year.

With most retirement plans, participants generally owe a 10% penalty for withdrawals before age 59½. With SIMPLE IRAs, participants owe a 25% penalty for such early withdrawals in the first two years they are in the plan. Subsequently, they'll owe the regular 10% penalty. During those first two years, no one can roll over a SIMPLE IRA account to a traditional IRA. Such rollovers are permitted once this period expires.

Living with the limits
If those are the basic rules, which companies should consider SIMPLE IRAs? These plans may work best for companies where the owners and other key employees are satisfied with maximum contributions of $23,000 or—for those 50 and older—$28,000 per year. In addition, SIMPLE IRAs may be ideal for companies that have few employees, especially if those employees are likely to make minimal SIMPLE IRA contributions. The smaller the total amount of employee salary deferrals, the less money your company will have to provide as an employer's match. Our office can help you go over the numbers if you are interested in setting up a SIMPLE IRA. Your company generally must establish a SIMPLE IRA by October 1 in order to have the plan in effect for the current year.

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