Should You Turn to Convertible Bonds?

If you invest in the volatile stock market, it’s often feast or famine, especially in this current environment. But there’s a way you may be able to hedge your bets. By investing in so-called “convertible bonds,” you can benefit rom rising prices while retaining some protection if prices should fall.

Background: A convertible bond is similar to a regular corporate bond that has a fixed interest rate and maturity date. It’s a debt of the corporation issuing it, so it must be paid whether the company is profitable or not. However, as the name implies, this type of bond may be converted into a fixed amount of stock in the company.

From a tax perspective, no current tax is due at the time of the conversion. If you sell the stock down the road, any gain is treated as capital gain. Therefore, for stock held longer than a year before it is sold, the maximum long-term capital gain rate is only 15% (20% for certain high-income investors).

Similarly, if you incur a loss on the sale of the stock, you can use it to offset capital gains and up to $3,000 of high-taxed ordinary income. Any excess is carried forward.

Main attraction: Essentially, you benefit from an increase if the price of the stock goes up, but you don’t have the same level of risk if the stock goes down. That’s because convertibles have a built-in safeguard. When the common stock is selling below the conversion price, the bond won’t sell for any less than its value as a bond.

Suppose you buy ten convertible bonds of XYZ Corp. for $10,000 with a conversion privilege of 50-to-1 (i.e., each bond can be converted into 50 shares of common stock). The price of XYZ stock was $15 when you bought the bonds. When XYZ reaches the price of $20, you decide to convert the bonds into 500 shares of stock. If the stock then reaches, say $25, you can sell your shares and collect a $2,500 gain ($12,500 – $10,000).

Conversely, if the value of the bonds falls, you won’t be hurt as much. For instance, if the price falls by 20%, the resulting value of the bonds may decline by only 10%. (These figures vary.)

Of course, convertibles aren’t without potential drawbacks. Consider the following:

Usually, convertibles produce a lower yield than comparable corporate bonds, due to the conversion privilege.

For certain convertibles, the value of the common stock you will receive on exchange is low, so it will be years before the conversion privilege is worth anything.
Most convertibles can be “called” with little warning. The issuer is unlikely to allow the stock price to increase substantially above the conversion price, so your profit potential is limited.

With some convertibles, the price of the common stock may high, so you have to pay a sizeable premium for the conversion privilege.

Caution: This sophisticated investment isn’t for novices. Factor in the financial and tax aspects and weigh the risks.