Convertible bonds have been the focus of numerous articles and commentary from the financial press over the past several months. What are they? Are they useful investments for the individual investor? A convertible bond is a bond issued by a publicly traded corporation that gives the bondholder the option to convert the bond to a certain number of shares of the corporation’s common stock at a specific price. Because you receive this ‘option’ to purchase stock, the yield that you get on your bond will be lower than the yield on a regular bond of equal quality and maturity. Convertible bondholders are essentially creditors of the issuing company who have the right to become owners.
Convertible bonds are not a new investment product and, in fact, became popular in the latter part of the 19th century when the railroad and telephone companies used them as a means of financing their expansion. Some of their advantages include the ability to capture additional profits should the stock price rise above the conversion price. If the stock does poorly, you have the safety of owning a bond and collecting interest. As with all financial products, advantages come at a price. As I have already mentioned, you will receive a lower yield than you would for a comparable non-convertible bond, so if you never convert to shares of stock, you have earned a sub-par return. Also, most convertible bonds are callable at the option of the issuing company at a price that effectively limits your profit potential should the stock price rise significantly.
Analyzing which convertible bonds to purchase is a daunting task for most investors since it requires an in-depth understanding of bonds, stocks and corporate analysis. Your best bet is a convertible bond fund run by an experienced manager. Consider no-load Vanguard Convertible Securities (VCVSX) run by manager Larry Keele, whose fund has earned a 10.3% annualized return over the past 3-year period. Convertible bond pioneer, John Calamos, along with Nick Calamos, manage the Calamos Growth and Income fund (CVTRX), which allocates approximately 58% to convertible bonds with the remainder invested in stocks. This load fund, which earned 10.68% annualized over the past 3 years, can be purchased on a no-load basis through Charles Schwab & Company.
Are convertible bonds an appropriate investment for the individual investor? Sometimes referred to as ‘chicken stocks’, convertible bonds can provide risk adverse investors a way to participate in the often volatile stock market while reducing risk. You are effectively combining the upside potential of owning stocks with the stabilizing effect of owning bonds. An added benefit is that convertible bonds are not directly correlated with either bonds or stocks, thus adding to the overall diversification of your portfolio. From an asset allocation perspective, they should be included as part of your fixed income allocation, rather than your equity allocation. Convertible bonds are not for everybody but they are a valuable investment tool to add to your toolbox.