It is not necessary to get tangled up in the intricacies of convertible bonds to understand them or the upsides and downsides of investing in them. Simply explained, convertible bonds are nothing more than corporate bonds that may be converted into common stock of the issuing company.
In many ways, convertible bonds are financial instruments that appeal to investors who like a certain corporation in terms of growth potential but they are not sure just how much they trust their judgment.
While bond holders are lenders of money to corporations, earning interest as their incentive, convertible bond holders have those traditional benefits plus the possibility of converting bonds to equity, changing their status from lender to owner of common stock shares in the company; thus the term convertible bonds, meaning converting from debt holder to ownership.
Realize this: The corporations issuing the convertible bonds have a right to convert the bond into a specified number of shares of common stock. At the time the bond is issued, the conversion is detailed with the number of shares that can be converted; the stock price at which the conversion can occur; and the time frame. In other words, it is solely at the discretion of the issuing corporation.
From the investor’s viewpoint, if the company’s shares rise, the bonds do well. If on the other hand, the shares fall in price, the investor continues to receive the semi-annual interest payments and the promise that the securities will be repaid (principal returned) at face value at maturity. Investing in convertible bonds can be an attractive alternative to other financial instruments.
Convertible bonds usually earn a lower interest rate than regular bonds because the theory is that the price of the bond will rise as the value of the underlying stock rises. But proceed with caution. While investing in convertibles does limit your downsize risk, it is at the expense of capping your upside potential.
If you are interested in a company, it may be less expensive and offer greater potential reward to simply buy common shares in the company, rather than purchasing convertible bonds.
Other factors that impact a possible downside to convertible bonds are:
Convertible bonds are callable. This gives the corporation the right to redeem or call the bonds at its own discretion. You will get your initial investment back but the opportunities for gains possible in other investments that could have been made are lost.
The stock price has to reach a target price before you can convert your bonds.
You will receive a lower interest rate on the bond and if the stock declines, the bond price drops. It is possible that interest rates rise and the stock falls.
If you are still uncertain as to whether purchasing convertibles are right for you, consider these facts:
1. When the corporate bonds are issued, they look just like all other corporate bonds but with a lower interest rate. Why? Because convertibles can be converted into stock, so the bond owner potentially benefits from a rise in the price of the common shares.
2. If the stock performs poorly there is no conversion and the investor is stuck with a sub-par interest rate return, probably well below what could be earned on non-convertible corporate bonds.
There is always a trade off between risk and return. Before investing in convertible bonds or any other financial instrument, it is advisable to seek professional counseling. Convertible securities are usually bought by investors who want higher income than what can be received from common stock combined with a greater potential for appreciation than what can be received from regular bonds.
The surest way to invest in such fixed income securities as convertible bonds is through a bond mutual fund offered by reputable securities dealers. Such funds are under the guidance of professional managers whose job it is to have access to extensive research and market information that is usually not readily available to individual investors.
Few investors have the expertise to actively select and monitor the thousands of bonds available. Check with the well-known security firms and others on-line but make certain they produce proof of the performance of their mutual bond funds and offer evidence they have the expertise and integrity to guide you through to a decision.
Tell them you want to know how to save money on transaction fees but compare one response to the other before making a final decision. What about inactivity fees’?
Remember, investments such as convertible bonds are not FDIC insured instruments. The value of your investment can go down or even be lost. There are no guarantees that you will recover your initial investment.