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Convertible bonds are an attractive vehicle for investors who want equity-like returns but cannot bear the volatility of stocks. A convertible may also provide more current income than the underlying stock. A convertible bond is a bond that can be exchanged for stock at a certain price ratio. As a bond or a debt obligation of the company, the convertible pays you interest periodically and then pays you back your principal at maturity even if the stock declines in price. It also gets paid off ahead of the stock if the company files for bankruptcy. These bondlike characteristics usually keep the convertible from falling too far if the company has poor results.
The trouble with straight bonds is that your return is limited to the principal plus interest. And prior to maturity, straight bonds can fall in price when interest rates rise. However, a convertible gives you considerably more gain potential. If things go well for the company and the stock rises, you can exchange your convertible for stock and participate in most of the equity gains. Moreover, this equity gain potential often reduces the negative effect of a rise in interest rates.
Of course, there is no totally free lunch. From a bond investor’s point of view, convertibles usually pay lower rates of interest than straight bonds, and they are often junior in right of payment (meaning that they are less likely to get paid off if the company files for bankruptcy). From the stock investor’s point of view, the exchange rate for the stock is usually set at a high enough level that you give up some of the upside if the stock rises.
But for those willing to make these compromises to reduce volatility, Convertibles can be very appealing. Convertibles can be particularly attractive in turnaround situations, which often have great gain potential but also significant risk of loss if the turnaround doesn’t pan out. If you can find a convertible where the stock price is not too far below the conversion price, you can capture most of the gains if things go well, and your risk of loss is significantly reduced if things go badly. Read more in "Convertible Bonds: Much Of The Upside With Less Downside."