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Convertible Investments for a Cloudy Day

Steve Klouda

Investing inherently includes an element of risk, particularly within industries where disruption is the status quo. Of course, that's typically where the bigger opportunities are, but that doesn't change the fact that the stocks in these industries sometimes produce stomach-churning volatility. Using convertible securities to potentially mitigate the ups and downs of high growth (but highly volatile) stocks may help investors sleep easier at night while still getting exposure to exciting long-term trends.

The cloud computing industry provides a good example of how we can use convertibles in this way. There's no doubt that businesses that focus on the cloud are riding a secular wave of demand. They are at the intersection of multiple demand waves as they benefit from the explosion of social media, faster network speeds, the massive creation of data, the subsequent need for additional storage, and economies of scale. The cloud is changing the way consumers live and how companies conduct business. This is creative destruction at its finest.

However, because of the upward moves in some cloud stocks, a few pundits have drawn parallels to the tech bubble of the late '90s. And yes, cloud companies are experiencing tremendous rates of growth and levels of volatility that we saw with some tech stocks back then. But there are important differences between the two. First, many of the cloud companies (at least the ones we favor) have balance sheets that are in far better shape compared to the dot-com names of the '90s. Most have significant amounts of cash on hand that can provide the necessary capital to grow their businesses and provide for a rainy day. Unlike the debt-laden telecom companies of the late '90s, the convertible bonds issued by today's cloud companies often are the only debt on the balance sheet, which offers the possibility for issuers to improve their capital structure quickly, should the stock rise above the exercise price over the next few years.

The second difference is the structure of the convertible itself. Most of the convertibles issued today by cloud companies have maturities of only five years, attractive conversion premiums of approximately 35%, and even a little income thrown in for good measure. If the long-term theme of cloud computing continues to play out and the stocks do well, the convertibles would be positioned to participate in the large majority of the upside. But if the stocks falter, the convertible holder should be insulated from most of the downside. Additionally, the relatively short five-year maturities of most of these convertibles mean duration risk should be reduced, an increasingly important consideration for fixed-income investors.

We've identified a number of cloud companies with the criteria our investment process favors: a great secular theme, underlying growth prospects, solid balance sheets. By participating via attractive convertibles, we believe we are better positioned to capture an asymmetrical risk profile, with more upside equity participation than downside.

The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.

The information in this report should not be considered a recommendation to purchase or sell any particular security. Convertible securities entail credit risk and interest rate risk.

Conversion premium is the amount by which the market price of a convertible bond exceeds conversion value, expressed as a percentage. It is a gauge of equity participation. Duration is a measure of interest rate sensitivity, with longer durations indicating greater sensitivity. Exercise price is the price at which the underlying stock can be purchased.

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