Whenever I talk to groups of investors I often discover that your average investor doesn’t know a whole lot about convertible bonds, and that’s ok. They know all about stocks, and they know all about bonds, but convertible bonds are a whole different beast.
So what are convertible bonds? Well basically they are what we like to refer to as hybrid securities. They usually carry a fixed interest rate just like a bond but in the future you may be able to exchange them for a specific amount of common stock in the underlying company that has issued the bond. So you get the best of both worlds, the steady and reliable income that a bond produces, and the upside potential for growth that a stock allows for.
Because that’s the problem with bonds, there is no upside growth potential. A bond is a contract. You agree to lend the company a certain amount of money and in exchange they agree to pay it back with a certain amount of interest over a certain fixed period. If next year the company comes out with a brand-new earth shattering product and their stock shoots through the roof, you don’t get any of that upside as a bond investor.
Convertible bonds fix that problem allowing you to take advantage of the fixed income opportunities that bonds give you and at the same time giving you the opportunity to take advantage of increases in stock price should something exciting happen to the company down the line.
One disadvantage that they do offer is that often times the interest that they pay will be slightly less than you would get if you owned a straight bond; but that’s merely the price you pay for the potentially unlimited upside that the convertibility offers.
Convertible bonds can often be a little difficult to understand because they use fairly complex pricing and many individual investors sometimes end up paying more than they should because they don’t understand the math involved. But then again, you are trying to get the best of both worlds so maybe that’s just the price you have to pay.
Also realize that a convertible bond is tied both to the bond market and the stock market. What that means is if the bond market drops and the stock market drops, your convertible bond may drop even more because it’s tied into both of those dropping markets. This can offer significant risk if you’re not careful.
Finally if you want to convert your bond in the stock, wait until after the next interest payment because interest payments are usually paid semiannually and do not accrue so you want to be sure to collect that interest before you convert the bond into a stock.
Hopefully now you know what you need to know in order to make a good decision about whether or not to purchase convertible bonds for your investment portfolio.