Shares: How to convert risk into profit: Convertibles offer investors a good hedge in the depressed equity market, Quentin Lumsden reports

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The Independent Online
YIELDS on government stocks have risen in recent weeks from under 9 per cent to around 9.2 per cent. They could rise further, given the present gloom among investors about prospects for the UK economy. But it seems unlikely that there is much downside risk in gilts given the low level of UK inflation and likelihood of further declines next year.

The prize for the investor prepared to buy longer-dated gilts now is an excellent running return, way above inflation, and the prospect of substantial tax- free capital gains. Market analysts believe that on a one-to- two-year view, yields could drop to 8 per cent or even lower. That implies capital gains of 12 to 15 per cent on top of the annual income return.

The problem for the gilts buyer is the old fear that whenever gilts go up, equities go up by more. This is a particular risk at present, because the additional yield offered by gilts over equities is lower than it has been for nearly three decades. Thus, by historical standards, shares look exceptionally cheap relative to gilts.

The problem for the investor is to know whether this is a cyclical phenomenon or a whole new ball-game. If the latter, then maybe gilts will be the best investment for the next couple of years. Others suspect, as I do, that the first sniff of sustainable economic recovery will see shares take off.

A way for investors to have their cake and eat it is to buy 'convertibles' - stocks that combine the characteristics of fixed interest and equity. They offer a fixed return, significantly higher than that offered by the same companies' ordinary shares, but can be converted into shares if the share price rises high enough to make conversion worthwhile.

Such pessimism currently surrounds shares that it is possible to buy convertible stocks offering yields considerably higher than those of gilts, with the right to convert into equity as a bonus. Examples of high returns are Slough Estates, convertible on a yield over 12 per cent, and the leisure group Rank Organisation, offering a yield of 11.5 per cent. Investors are clearly nervous about both, but as long as they can survive the recession, they will go on paying the dividends on their convertibles even if they have to cut or pass on their equity dividends. When the gloom lifts, the yield on the convertible will quickly fall back to, say, the 9 per cent yields offered by gilts, and offer substantial capital gains. And if they ever seriously come back to investor favour (an excellent possibility on a longer view), the conversion rights could be very valuable.

Other stocks with convertibles offering yields of more than 12 per cent include P & 0, British Land, BICC, Great Portland Estates and British Aerospace. But there are healthy returns available for much lower levels of risk.

An average running return (annual income) of around 9.5 per cent could be obtained from convertibles issued by Hepworth, Hanson, Blue Circle, Carlton Communications, BBA, Hambros and Williams Holdings.

(Photograph omitted)

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