Do you like the security of bonds with the upside of stocks? That is the story companies selling convertible securities want you to buy into. How does it work?
A convertible security is usually a bond that can be converted into the company's stock at some point before maturity. Sometimes it is a preferred stock with a fixed dividend that can be converted into regular shares of the company. When you buy a convertible security, you are buying a bond with a call option on the stock. The bond pays you the coupon. The option gives you the right but not the obligation to trade the bond for the stock in the company if it is to your financial advantage to do so (the option is in the money).
Because you are buying an option bundled with the bond, you have to pay for it. You pay for the option by receiving a lower coupon than you would receive on a regular bond from the company.
Sometimes the company has the right to force the conversion. You effectively sold a put option to the company. The company has to pay for the option. In those cases, the coupon on the convertible should be higher than for a regular bond.
If you bought a convertible 5-year bond with a 4.5% coupon from a company when the stock was selling for $20 per share it might be convertible at $30 per share. If the price of the stock goes down you get the coupon from the bond and get par back on the bond at maturity. If the price goes up past $30 per share you can convert into shares and lock in a $10 per share gain on the transaction.
If you like the concept but can't find a convertible bond on a company you like you can often create your own convertible by buying the bond and buying a LEAP call option on the stock at the same time.
I know that bonds appreciate in value when interest rates have declined (below the market price at which the bond was purchased), and bonds generally react to economic data based upon past events.
Stocks also appear to react positively to an expectation of lower interest rates (i.e. the expectation of a broader monetary supply, as one catalyst for a stronger economy), but sometimes stocks also appreciate in value as interest rates are expected to escalate, as when the Fed is anticipated to take decisive action limiting inflationary pressures. Stocks react to future economic data and expectations, not the past.
Under what ideal scenario of economic conditions would convertible bonds best serve the needs of most investors, and why?
Posted by: Bob Hansell | August 1, 2006 6:09 PM | Permalink to Comment