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Convertible bonds are xed-income investments with features that allow the holder to convert the bonds into a specic amount of stock shares in the same company. They are best-suited for investors who seek both income from the bond and the growth potential of the stock.
Convertible bonds were key nancial building blocks in our Western heritage, fueling the growth of railroad and telephone companies in the late 1800s. The bonds virtually disappeared when double-digit ination rates in the 1970s sent bond buyers searching for other ways to protect their investments. Now, investors who seek both interest income and the ability to grow principal in the markets appreciate the exibility offered by convertible bonds.
Because convertible bonds can be turned into common stock, they usually pay a slightly lower interest rate than bonds without this feature. If the stock price rises, the bond price should also rise. Since most convertible bonds are also callable, the company can force investors to convert the bonds to common stock by calling the bonds in a practice called forced conversion.
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When a bond is converted to common stock, the company that converted the bond to stock has less debt: what was debt becomes equity. As a result, converting debt (bonds) into equity (stock) dilutes the value of all the shares in the company the percentage of each stockholders equity in the company has been reduced. If the companys stock declines to a price that makes the convertible feature of the bond worthless (but the company continues to make interest and principal payments), the bond will trade based on its yield like any other bond.
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Call features. Finally, when investing in convertibles, it is essential for investors to know the bonds call features when the issuing company can redeem the bonds for common stock or cash. A call can be made even when the price is below the bonds conversion value. Most convertible bonds have call protection for a minimum of two years from the date of issue.
Potential benets
With convertible bonds, you can receive income payments from a bond while reaping some of the benets of a companys rising stock price. If the stock is not performing well, the bondholder has priority to be paid interest, ahead of any stockholder dividends. Also, if the stock price increases, the bondholder has the choice of converting the bonds into a specied number of common stock shares.
Credit ratings
Moodys Investment-grade ratings Highest possible credit rating principal and interest payments considered very secure. High quality differs from highest rating only in the degree of protection offered to bondholders. Good ability to pay interest and principal more susceptible to adverse effects due to changing conditions. Adequate ability to make principal and interest payments adverse conditions are more likely to affect ability to service debt. Speculative ratings Issuer faces ongoing uncertainties or exposure to adverse business or economic conditions. Greater vulnerability to default, but currently meeting debtservice requirements. Current identiable risks of default in some cases, bonds may already be in default. Bonds in default. Ba BB BB BB Aaa AAA AAA AAA Standard & Poors Fitch Duff & Phelps
Aa
AA
AA
AA
Baa
BBB
BBB
BBB
Caa C
CCC D
CCC D
CCC D
This chart will help you identify the meanings behind the credit ratings assigned to convertible bonds. Bonds rated Baa/BBB or above are considered to be of investmentgrade quality, meaning that the bonds can be considered for the conservative investor. Corporate bonds rated below this level are considered to be speculative or high-yield investments and are only suitable for investors who are able to accept a greater degree of risk from their investments in exchange for a potentially higher return.
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Glossary
Call protection. The period of time during which a convertible security cannot be called by the issuing company. Conversion price. The price (or cost) at which a convertible security can be converted into the underlying common stock. Conversion price equals the par amount of the security divided by the conversion ratio. Conversion ratio. The number of shares into which a bond or preferred stock may be converted. Coupon or dividend. The xed interest rate paid to the holder for the term of the security. Parity. Equity value of a convertible security, determined by multiplying the conversion ratio by the stock price. Premium. The percentage by which a convertible security is valued over its parity.
Risk factors
Convertible securities typically involve credit or default risk, event risk, call or redemption risk and market risk. Credit risk. Credit risk is the risk that an issuer will be unable to make the periodic interest payments or repay the principal. When a bond stops paying interest or the issuer is unable to repay the principal, the bond is considered to be in default. If the corporation declares bankruptcy and defaults on its debt, bondholders, as creditors of the corporation, will have priority over stockholders in the bankruptcy proceedings. To assess a bonds credit risk, investors can look to the credit ratings assigned by independent credit-rating agencies, which include Moodys Investors Service, Standard & Poors, Fitch Investors Service, Inc. and Duff & Phelps Credit Rating Company. Normally, the lower the rating on a bond, the higher the potential yield. Issuers must compensate investors for assuming additional credit risk by offering higher interest rates on corporate bonds. Please make sure to check the credit-rating of a corporate bond before you make a purchase. Event risk. Event risk in convertible securities is normally associated with events affecting the corporate issuer. Leveraged buyouts, mergers, takeovers or recapitalizations can often increase a corporations debt load. These factors can have a serious impact on the credit ratings assigned to a corporate issuer, as well as the value of the bond. Call or redemption risk. Often, convertible bonds are issued with redemption features that allow a corporate issuer to redeem or call an issue or to force a conversion at a stated date before the bond matures. Market risk. Convertible bonds, like other types of xed-income investments, are always subject to market risk. This refers to the risk that an investor faces if the bond needs to be sold before its stated maturity. As interest rates increase, bond prices will decrease and, conversely, as interest rates decrease, bond prices will increase. While it is true that rising interest rates will have a negative effect on the bond value of the convertible security, the fact that the convertible also has equity value will tend to temper that effect. If the stock market is rising, convertible values will generally be more positively affected by rising stock values than negatively affected by rising interest rates. However, if the stock market declines at the same time that interest rates rise, convertibles normally lose value.
Summary
Convertible bonds can be a valuable addition to your xed-income portfolio. Your Financial Advisor can help you determine whether these bonds will suit your overall investment objectives. For more information on convertible bonds and your portfolio, consult your Financial Advisor today.
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