The Advantages of Convertible Bonds
- Convertible bonds can be changed to shares of common stock.chart background image by Stasys Eidiejus from Fotolia.com
Convertible bonds function just as any other bond. The corporation that issues the bond pays an annual or semiannual coupon for the duration of the bond and returns the principle to the bondholder upon the bond's maturity. The interest rate of these bonds varies according to the financial stability and history of the company issuing them. They also are issued for various terms, some maturing quite quickly, while others constitute long-term investments. However, the defining characteristic of convertible bonds is the ability for them to be changed into shares of common stock. - One of the most important advantages of convertible bonds is their status as a debt instrument. Corporations are required to service debt before distributing profits. Even in the case of severe financial distress, debt, including all types of bonds, must be paid before holders of common stock receive anything. So, convertible bonds provide a solid minimum return. If they are not converted, a nominal loss cannot be realized.
- The price at which convertible bonds can be changed to common stock and the proportion of bonds to shares is designated before the bonds are purchased. However, common stock is quite volatile, meaning that its price is subject to considerable and rapid fluctuation. If the company does well and its stock price increases substantially, the bonds can be converted into common stock. If the price decreases, the bonds will simply not be converted and return income as bonds. This combination of substantial upside potential and limited downside risk makes them a potent holding.
- Convertible bonds also offer a method for an interested investor to become involved in a company. If a firm is perceived as having considerable potential, but you are wary about purchasing common stock, you may opt for convertible bonds. In this way, you are protected from the downside risk of a plummeting stock. But if the company prospers, the shares need not be sold upon conversion. The converted shares may be a means of participating in the direction of the company via shareholder vote. If the interest shows long-term potential, the shares may be retained for their dividend income potential.
- Convertible securities present complexities that may daunt the casual investor. But, many mutual funds participate in the market for convertible bonds. An investor interested in tapping into this sector of the financial market can invest in one of these funds and profit from the advantages of professional management of such securities without having to become an expert in the details of their operation himself.
