Convertible
Securities
In difficult times, finding investments that offer growth potential while minimizing volatility can be challenging. Depending upon your risk tolerance and goals, there are investment options, such as convertible securities, available to diversify your portfolio that can reduce downward volatility and capture upside movement.
Many companies issue convertible bonds and/or convertible preferred stock. There are differences between the two, so for this installment we will be discussing convertible bonds.
What is a convertible bond? Simply put, it is a corporate bond that has the special feature of being able to convert to a set number of shares of common stock. This allows the bondholder the opportunity to participate in upside growth of the common stock. Should the value of the underlying common stock grow in value it may be advantageous to convert the bond to stock. If the company’s stock declines to a price which makes the convertible feature of the bond worthless, as long as the company is solvent, the bond will trade based on its yield - like any other bond.
Convertible bonds are a hybrid security, part bond, part common stock. Some of the factors that need to be considered before purchase include: the bond’s interest rate and yield, how many years remain before maturity, the common stock price applicable upon conversion, downside risk and possible rewards in converting to a stock, and how it compares to a regular bond. Due to the complexities of these investments, most investors are exposed to them via mutual funds, some of which specialize in managing risk and reward.
The convertible feature has a cost, in that generally these bonds pay a lower coupon than comparable corporate bonds. The good news is that their default risk tends to be somewhat lower than that of straight corporate bonds, which may be a function of the lower coupon payment. Of course, as with other investments there are risks associated with convertible securities, such as the risk the issuing company will become insolvent. However, in the event of a liquidation of the issuing company, holders of convertible bonds would be paid before the company’s common stock holders.
Convertibles can be an excellent tool for managing downside risk and capturing upside growth, while also providing diversification in a portfolio. For more information about convertible securities or other risk management investments, please call our office.
