Convertible Bonds - A Good Investment?

Some financial products straddle the fence between two worlds. Convertible bonds are such products, offering benefits for the investor from the world of bonds and the world of stocks.

Not all products that attempt this multiple personality existence work. However, convertible bonds can be an attractive investment under right circumstances, but you should be very careful of several potential problems.

Corporations issue convertible bonds and carry the right to convert the bond into a specified number of shares of common stock.

Here’s how they work. At the time of issue, the bonds spell out:

• The number of shares that can be converted
• The stock price at which conversion can occur
• The time frame

Convertible bonds usually earn a lower interest rate than regular bonds because the price of the bond will rise as the value of the underlying stock rises.

The bonds benefit in a rising stock market, but still pay interest if the underlying stock doesn’t rise.

Proponents of Convertible Bonds

Proponents point out that investors potentially get the best of both worlds: interest payments and higher bond prices if the underlying stock rises.

However, there are some serious flaws in the convertible bond picture. Here are some things you should consider before buying convertible bonds:

• Almost all convertible bonds are callable, meaning the corporation can redeem the bonds at its discretion. You get the face value back, but may have to reinvest the money in a less attractive investment.
• The stock price has to hit a certain number before you can convert. This number may be quite high. This is the conversion premium. If you want to own the stock, you are better off buying it at the lower current price rather than waiting for it to hit this premium.
• You receive a lower interest rate on the bond and if the stock declines, the bond price drops. In the worst of all worlds, interest rates rise and the stock falls.

Conclusion

Are convertible bonds bad investments? Not necessarily, however, you must factor in all these variables to see if a particular bond makes any sense. As with any investment, do your homework.