Convertible bonds are issued by corporations and they can be converted into a (predetermined) amount of the company's equity at particular times during the life of the bond (usually 25-30 ears in term). The bondholder determines when the bond is to be converted, not the corporation. This type of bond gives the bondholder the right to acquire the issuer's common stock directly from the issuer rather than on the open market. The bond indenture will detail the terms under which this exchange can occur.
Convertible bonds are considered to be a hybrid security, that is, they have aspects of both bonds and stocks. Convertible bonds are often categorized as subordinated debt, and therefore are a bit more risky than unsubordinated debt. If the issuer goes through rough financial waters, subordinated debt holders fall behind unsubordinated debt holders concerning principal repayment.
When it comes to trading convertible bonds, remember that the word trading more accurately means "buying and selling." Firstly, convertible bonds are considered to be a safer investment compared to stocks, but they can still provide stock-like returns. Secondly, they are steadier and less volatile than stocks. For instance, the value of a convertible bond can only fall to a price where the yield would be the same as that of a non-convertible bond of the same terms, which offers protection in a bear market. Convertible bonds also allow the investor to participate in the profits, too, if a stock goes higher.
Convertible bonds provide investors with a vehicle that features lower risk and lower yield, yet also allows the investor to take advantage of a bull market. When choosing an investment option, research is necessary to see if this particular security will be profitable. It is good to remember that convertible bonds sell at a premium to the stock's value. The bondholder is therefore making a tradeoff, lower yields up front for possible gains in stock price down the road. If these gains are not attained, the bondholder has in effect given up the yield spread between the nonconvertible and convertible bonds. It is wise to analyze the quality and stability of a company before one buys bonds or stocks. Does the company have the wherewithal to withstand a recession or economic downturn?
Convertible bonds are a good choice for an investor, but discretion must be used before buying them.