By FPA member David Zuckerman, CFP®, CIMA®

Last Updated: February 28, 2011

For investors looking to capture gains from a rally in stocks without taking on the risk of owning equities outright, investing in convertible bonds may be worth considering because convertible bonds are a type of hybrid security that blends some characteristics of both stocks and bonds. Stock ownership represents an equity interest in a company, meaning that a stockholder owns a piece of a company and its earnings. Bonds, on the other hand, represent debt. Bondholders lend money to companies, and are paid interest until a bond matures and the principal is paid to the bondholder. The difference between convertible bonds and traditional bonds is that when traditional bonds mature, the final payment is made in cash. With a convertible bond, however, you get to choose whether you want to be paid in cash or in company stock.

In order to illustrate the difference, consider two bonds issued by the same company. 

The company’s traditional bond has a face value of $1,000, pays 5 percent interest and matures in 15 years. That means that if you buy the bond, you pay $1,000 and get 5 percent interest on your $1,000 every year until the bond matures in 15 years. When the bond matures you get your $1,000 initial investment back in cash.

Then, there is the convertible bond that is issued by the same company. It is different from the traditional bond because, when the bond matures in 15 years, you can choose to get paid 20 shares of the company’s stock instead of the $1,000 that you initially invested. Whether or not you choose to get paid in stock depends on whether the 20 shares of stock are worth more than $1,000. In this example, if the company’s stock is trading more than $50 per share, converting into stock makes sense. And, as a convertible bondholder, you do not have to convert into stock if the share price is less than $50. The conversion is just an option that you can exercise if it makes sense. 

But keep in mind that the option to convert your bond into shares of stock does have a price that comes in the form of a lower interest rate. So, while the traditional bond pays 5 percent interest, the convertible bond might pay only 4.5 percent. This is because investors will sacrifice some interest income for the opportunity to capture additional return from the potential appreciation in the share price of stock.

Is the half percentage point that you give up in interest worth having the option to convert your shares into stock? This will depend on your opinion of the company’s stock, the amount of income you need, and your risk tolerance.

So, compared with a traditional bond, the value of a convertible bond is tied much more closely to the value of the company’s stock and its profitability. Convertible bonds provide an opportunity to participate in the success of a company without taking as much risk as buying stock. But your upside will still be more limited than if you just owned the stock outright. The reason for this is that convertible bonds have call provisions for the issuing company. A call provision means that if the company’s stock rises significantly, you can be forced to convert your bond into shares of stock before the bond matures. In our example, if the price of the stock rises to $60, the company might choose to convert its debt into stock prior to maturity. Call provisions that force conversion at predetermined prices can allow companies to avoid large financial burdens resulting from rising stock prices.

So, convertible bonds can give you a chance to participate in the success of a company with less risk than buying stock, because, as long as the company stays solvent, the worst case scenario is that you are paid interest and receive your initial investment back at maturity. But, in return, a convertible bond will pay less interest than a traditional bond of the same maturity that is issued by the same company. And due to call provisions, the sky is not the limit when it comes to returns from convertible bonds.

As such, convertible bonds are a type of hybrid security that is potentially more rewarding, but riskier, than traditional bonds. Convertible bonds are also less risky, and potentially less rewarding, than stocks. If you are thinking that bonds may be a bit too conservative for you and that stocks may be a bit too aggressive, convertibles may well be worth consideration. 

But convertible bonds are relatively complicated and complex securities because pricing the trade-off between interest rates and probabilities of future stock appreciation is very difficult. In addition, there are different types of convertibles, such as contingent convertibles, and there are other factors from both the stock and bond markets that affect prices. In principal, exposure to convertible bonds can be obtained through mutual funds, exchange traded funds, or even through the purchase of individual convertible bonds. But if you think that convertible bonds might be a good fit for your investment portfolio, a good first step is to consult with a financial planner who can help determine the type of exposure that is right for you.

FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, Calif.  He serves as Director of Public Relations for the Los Angeles chapter of the Financial Planning Association.