The Only Guide to Alternative Investments You'll Ever Need: The Good, the Flawed, the Bad, and the Ugly

Chapter 13. Convertible Bonds

Convertible bonds are hybrid securities that have characteristics of both stocks and bonds. The attraction of convertible bonds as alternative investments is that they seem to offer the best of both worlds to the risk-averse investor—the upside potential of equities and the safety of corporate bonds. However, as discussed previously, there are no free lunches in the world of investing (with the exception of diversification). Investors should gain an understanding of all of the issues related to convertible bonds before deciding if they should play a role in their portfolio.

As the name implies, a convertible bond gives the holder the option—the right, but not the obligation—to exchange a corporate bond for a predetermined number of shares of common stock in the issuing company. It is the tantalizing right, but not the obligation, to convert a bond to equity that creates the perception that an investor can enjoy the best of both worlds. If the stock does well, the holder can convert to equity, but if it does poorly, the investor retains the safety of the bond and the coupon payment. Not surprisingly, the market recognizes this option has value and assigns a "price" for this flexibility—the interest rate on the convertible bond would be less than it would be on a similar nonconvertible debt issue.

As for the conversion price, it is typically set well above the current market price. Two key factors determine how much the option to convert is worth: (1) how ...