August 29, 2011 by tfroberts

Convertible tops allow car drivers to enjoy sun and fresh air when conditions are right. You are not cooped up in an enclosed vehicle and you can put up the top when it rains or temperatures are not ideal. You have the best of both worlds although, like everything else, there may be some quirks to address.

In the investment world, convertible bonds have similar characteristics. These investments are a hybrid of a fixed rate bond that has the ability to be converted to stock if conditions are right. As a bond, they provide steady interest payments. The contract spells out how the bonds can be exchanged or used to buy stock at a specified rate. If the stock price increases, you can benefit by having access to shares. If the stock price declines, you still receive the interest. Some caveats; the interest rate is less than a similar bond and the value of the convertible rises at a slower rate than the company's common stock prices. The contract may also contain provisions for the bond to be called by the company as well as the option for you to sell the bond back at a specified price.

The advantages are that you can receive return via interest if the stock market is flat while not giving up the potential for appreciation, capital gains. Another advantage is the smoothing of returns, lower volatility, of this investment. The disadvantages include lower interest rates, inflation risk, company credit risk and slower price increases. If the markets have been wandering with no clear direction, convertibles tend to perform well relive to plain vanilla bonds or stock holdings of the same company.

 

There are fewer avenues to purchase convertibles than other stocks and bonds. In addition to purchasing convertibles directly, there are a few mutual funds and ETFS.