Before buying, every investor should study the pros and cons of convertible bonds. These bonds-with-a-bonus may be converted into shares of stock when their prices hit a certain point. Thus, convertible bonds give purchasers income combined with a chance at capital growth.
The pros and cons of convertible bonds depend on the purchaser’s goals. In general, though, the chief advantage of a convertible bond is the equity kicker it gives an investor, who may receive some of the rewards of two very different investments. He gets stable income from the bond, and growth, perhaps, from the stock it may become.
One negative has to do with value. A hopeful investor can easily overpay for a convertible bond. The investor accepts a lower interest rate in exchange for the chance of getting stock at a good price, but the conversion may turn out to add negligible value. If that happens, an investor has loaned money at a lower rate than he or she could have gotten in an ordinary bond.
A convertible bond lets a company raise money at a lower rate than otherwise. In addition, a convertible bond is a way of increasing the number of a company’s shares without doing a secondary offering or stock split.
However, an investor may not be interested in the company’s viewpoint. He wants to know, from his own vantage point, the pros and cons of convertible bonds.
The chance of converting the bond into stock in a company is a convertible bond’s distinguishing feature. It gives investors the chance to participate in the future growth of a stock price, in a way that an ordinary bondholder does not. In this sense, a convertible bond is like a conservative investment producing an income stream, mixed with a riskier one, a sort of stock warrant.
At the same time, the owner of a convertible bond has a hedge against ill fortune for the company. Until conversion, his or her interest will be paid before the stockholders get their dividends, even if things get somewhat rocky for the company. Interest on the bond is usually higher than the dividend that shareholders get, too.
In addition, the price of the bond is unlikely to fall below its intrinsic value, which is the effective price of the related stock. In some circumstances, this will provide another floor beneath the bond price.
A company that issues new stock is telling the world that they think their shares are overvalued and worth selling, just as a company that buys back shares is demonstrating that they believe their stock is undervalued and worth buying. Yet convertible bonds are, in the end, a way of selling shares. Therefore, the company that sells them is also showing, to a degree, that the directors consider their stock too high.
In other words, anyone buying a convertible bond may in effect be paying too much for the stock.
If convertible bonds do convert to stock, the effect will be the creation of new shares. This causes dilution: The company is earning the same amount of money, but has to divide its profits among more outstanding shares. Dilution makes stock less valuable.
Another disadvantage of convertible bonds for the average investor is that they are relatively illiquid instrumennts. Most people will find that it is more efficient and economical to buy convertible bonds in a fund or EFT. Spreads and transaction costs tend to be high in this arena.
Vanguard offers a convertible bond fund, VCVSX, as do Calamos, CCVIX, and Van Kampen Harbor, ACHBX. The Spyder Barclays Convertible Bond ETF symbol is CWB.
Convertible bonds are a relatively conservative investment. They can resist market declines and yet respond to upswings. As always, though, investors should make sure that this investment fits their particular circumstances, and that they clearly understand the pros and cons of convertible bonds.