Convertible bonds are bonds that are issued by corporations and that can be converted to shares of the issuing company’s stock at the bondholder’s discretion. Convertible bonds typically offer higher yields than common stock, but lower yields than straight corporate bonds.
Pros and Cons of Convertible Bonds
Like regular corporate bonds, convertibles pay income to investors. But unlike bonds, they have the potential to rise in price if the company’s stock performs well. The reason for this is simple: Since the convertible bond contains the option to be converted into stock, the rising price of the underlying stock increases the value of the convertible security.
If the stock does poorly, however, the investor may not be able to convert the security to stock and will only have the yield to show for their investment. But unlike stock, convertible bonds can only fall so far — provided the issuing company remains solvent — since they have a specific maturity date when investors will receive their principal. In this sense, convertible bonds have a more limited downside than common stocks.
While convertible bonds have greater appreciation potential than corporate bonds, they may be also more vulnerable to losses if the issuer defaults (or fails to make its interest and principal payments on time). For that reason, investors in individual convertible bonds should be sure to conduct extensive credit research.
Example of How a Convertible Bond Works
Let’s say ABC Company issues a five-year convertible bond with a $1,000 par value and a coupon of 5%. The “conversion ratio” — or the number of shares that the investor receives if they exercise the conversion — option is 25. The effective conversion price is, therefore, $40 per share ($1,000 divided by 25).
The investor holds on to the convertible bond for three years and receives $50 in income each year. At that point, the stock has risen well above the conversion price and is trading at $60. The investor converts the bond and receives 25 shares of stock at $60 per share, for a total value of $1,500. In this way, the convertible bond offered both income and a chance to participate in the upside of the underlying stock.
Keep in mind, most convertible bonds are callable, meaning that the issuer can call the bonds away and thereby cap the investors’ gain. As a result, convertibles don’t have the same unlimited upside potential as common stock.
On the other hand, let’s say that ABC Company's stock weakens during the life of the security — rather than rising to $60, it falls to $25. In this case, the investor wouldn’t convert – since the stock price is less than the conversion price — and would hold on to the security until maturity as though it were a corporate bond. In this example, the investor receives $250 in income over the five-year period and then receives their $1,000 back upon the bond’s maturity.
How to Invest in Convertible Bonds
Investors who are prepared to do the appropriate research can invest in individual convertible securities through their broker. A number of major fund companies offer mutual funds that invest in convertibles.
Keep in mind, large portfolios of convertible securities — which funds and ETFs represent — tend to track the stock market fairly closely over time. As such, they perform more like a high-dividend equity fund. These products can provide an element of diversification and upside potential relative to traditional bond portfolios, but are not necessarily the best way to diversify for someone whose portfolio is primarily invested in stocks.