Convertible Bonds
Article Provided by FinancialContent
By Chris Stallman
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Convertibles.
No, we're not talking about the Dodge Viper that you've
been eyeing at the local car dealership. Convertible bonds are simply
bonds that can be later converted into stock.
Convertible bonds are
bonds issued by a company that are convertible into common stock.
Like all bonds, they also provide a yield (interest). However, this
yield is also slightly lower than most corporate bonds (bonds issued
by a company) offer. The current average yield is about 4%.
In a way, convertible
bonds act much like a mix between equities (stocks) and bonds. If
the price of the stock goes up, so does the bond. The bond price
usually goes up about 2/3 as much as the stock did. When the stock
declines, so does the bond but the bond usually does not depreciate
more than 1/2 as much as the stock did.
When a
convertible bond is purchased, it is given a conversion ratio. This
simply states how many shares of stock the bond can be converted
into per $1000. If the conversion ratio is 20:1 (20 to 1), then
the bond can be converted into 20 shares of the stock at a price
of $50 each. However, the conversion price is often valued above
(also called "premium to") the current stock price by
10-30%. This means that the stock may be trading at 40 or 45.
Therefore, the stock would have to go up until it reaches 50 before
a reasonable conversion can take place. If the stock kept going
up and reached 60/share, then the bond could be converted into $1200
worth of stock. This may seem a little confusing now but it is really
rather basic once you get the hang of it.
Advantages
These bonds offer a way to cushion the market fluctuations
while providing you with a very nice annual gain. In the past 10
years, convertible bonds have returned an average of 13% versus
the S&P 500's return of 18%.
Another advantage is that these bonds also offer a
way to receive income from many technology stocks. As well known,
many technology stocks do not offer dividends, thus not providing
for any income. By investing in convertible bonds, an investor can
receive income in the form of the yield.
Many convertible bonds are offered by small and medium-sized
companies which allow investors a slightly safer approach to getting
into the small and mid-cap sectors.
Disadvantages
Unfortunately, these bonds do have disadvantages. First
of all, the convertibles trade at a premium to the current trading
price. To make the conversion effective, you would have to allow
the stock to reach the conversion price. If the stock never reaches
that price, the conversion would be worthless but the bond would
continue to produce interest.
These bonds are also rather expensive and hard to get
a hold of. For the average investor, it may cost $50,000-$100,000
to produce a diversified portfolio of these bonds. That is why we
recommend you purchase them through mutual funds.
Finally, most convertible bonds are also "callable".
This means that the company may force the bondholders to convert
into stock. This does happen but not very often. The company does
this to limit their debt. Bonds are referred to as debt because
the money is leant to the company by the bondholder and the company
has the obligation to pay them back plus interest.
If you are interested in these bonds, you would definitely
want to look into mutual funds. Because these bonds are often rather
expensive and difficult for the average and beginning investor to
purchase, mutual funds offer these investments, usually through
low minimum investments. One such mutual fund, Calamos Convertible
A, has a low minimum investment of only $500 and a 10-year return
of 13.45%.
These bonds are a great way to provide a nice long-term
return with a little less risk. Through mutual funds, a young investor
can diversify their portfolio while not missing out on the excellent
gains associated with a bull market.
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