Convertible bonds or no?

They have advantages – and real drawbacks

Question: Wouldn’t a convertible bond be a preferable fixed-income investment compared to a standard bond because of the upside potential?

Answer: Convertible bonds may seem like great deals – after all, you get predictable income and the potential to profit if the issuing company’s stock price increases.

Perhaps the biggest downside is that convertible bonds generally pay significantly lower yields than comparable fixed-income securities. This is one of the main reasons companies issue convertible debt – it keeps borrowing costs lower. For example, if corporate bonds of a certain rating pay 5 percent annual interest, a company with that credit rating might be able to pay just 3 percent – or even less – on convertible debt.

Of course, if the company’s share price soars and converting those bonds into common stock becomes a profitable choice, that won’t be an issue for you as an investor. However, if the stock performs poorly, you’ll be stuck with a low-paying fixed-income security.

It’s important to realize that issuing companies generally have the right to force the conversion of their bonds if the stock price is higher than the conversion rate. Simply, companies only allow convertible bonds to rise by a certain amount – then they’ll become stocks. So, if you aren’t careful, buying convertible bonds can result in you having a higher stock allocation in your portfolio than you intended.

Finally, convertible bonds tend to be far more volatile.