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Understanding Convertible Bonds

Updated on February 6, 2013

Convertible Fixed Income

The convertible bond market is in a sense an asset class all to itself as a result of its hybrid nature. A convertible bond is essentially a bond issued by a corporation that allows the investor who holds the instrument to convert the bond to stock in the corporation based on a predetermined formula. This is typically an option and not a requirement. So in a sense you as the investor have the benefit of both a stock and a bond holding. Most convertibles will be issued with a maturity of at least 10 years. In most cases the coupon (interest rate) is issued at a lower rate than non-convertible issues by the same corporation.

The biggest benefit to the issuer/corporation is the lower interest payment. Should the bond get converted by the holder, the debt of the company disappears, yet they have diluted equity by issuing stock in replacement of the debt from the corporate treasury.

The benefit to the holder of the bond is they can simply hold the issue to maturity with a guaranteed rate of return like any other corporate note, with only the credit quality of the underlying issue to be concerned about. Should the pre-determined conversion price be appealing then the holder can benefit from participation in the stock price appreciation through the conversion. Additionally, while the average maturity is more than 10 years at issuance, the conversion feature actually lowers the average duration of a fairly well diversified convertible portfolio.

In terms of buying fixed income in general, the majority of the average American investors will be better suited to diversify their fixed income holdings through bond funds and ETF’s. For more information on this topic see below…

http://landmarkwealth.hubpages.com/hub/Bonds-or-Bond-Funds

In terms of risk and volatility, it should be noted that because of the conversion feature of these bonds, they more often tend to correlate to price movements in the stock market, rather than correlating with the rest of the investment grade fixed income markets which are more sensitive to interest rate changes. So as an investor, when you buy a convertible bond fund or an ETF, be prepared for the volatility. In general they tend to be less volatile than most stock funds with returns that are not that far from stock market like investment returns. However, if you are looking to balance risk with other stock based investments, convertibles will more likely increase your portfolios correlation and do little to reduce volatility.

For those investors who are looking to place a portion of their investments into convertible bonds and not inclined to research individual bonds and their features themselves, they may wish to utilize an active manager. In the market place of convertible bond funds that use active managers, Calamos Investments has essentially written the book on evaluating these securities. However, many of their funds are subject to sales charges if not bought directly through a fee based investment advisor. As such costs can be impactful to an investor’s portfolio, they should be evaluated carefully. Those investors who tend to take a more passive approach to investing may be interested in the far less expensive ETF market place. Companies like State Street Global Advisors offer convertible ETF portfolios with internal expense ratios as little as 0.40%.

When evaluating convertibles and the role they may play in your investment portfolio, this like any other investment should be done in the context of a larger long term investment planning strategy.


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    • LandmarkWealth profile imageAUTHOR

      LandmarkWealth 

      5 years ago from Melville NY

      Thanks...A diversified convertible portfolio would likely rise with rising rates, unless rates are rising in a late 1970's like stagflation environment.

      I happen to utilize a convertible position for my clients. However I actually use in the equity portion of the portfolio currently. In a bullish market a convertible fund will lag equities in all likelihood. But not by that wide a margin. Yet, produce less volatility. Case in Point...YTD as of Oct-16-2012 on the S&P is a positive 17 .71% While Convertibles are up about 13.20%. Look at 2008 and the S&P was off by -37% wheareas a convertible fund was off more like -25%.

      I would simply argue it reduces volatility and correlations if you treat it like an equity holding. If you treat is as a fixed income holding, be sure of a more bullish outlook, since correlations will go up not down.

    • bankscottage profile image

      bankscottage 

      5 years ago from Pennsylvania

      This is great info. Thanks. I have a small portion of my retirement funds in a convertible bond fund for many of the reasons you describe. I have stock, bonds, and alternatives. I am never quite sure what asset class to put the convertibles in. I am very worried at what will happen to bonds when the interest rates eventually go up (I know the price will crash). But, how would rising interest rates affect the convertibles (more like a stock or like a bond)?

      Voted up, interesting, and useful.

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