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Here's everything you need to know about convertible bonds.

Convertible bonds are just one way to expand your investment portfolio beyond the traditional stocks you may already be investing. This type of bond can offer the potential for higher returns to investors, but they also carry certain risks. Getting to know the ins and outs of how they work, as well as the pros and cons, can help you decide whether convertible bonds belong in your investment strategy.

What Are Convertible Bonds?

A convertible bond gets its name because it’s a corporate bond that can be converted into common shares of company stock. Essentially, they combine features of stocks and bonds into a single investment.

Companies typically issue convertible bonds to raise capital. Doing so can be cheaper than taking on new debt. The company then pays out interest to investors who purchase the bonds. That puts them in the fixed-income category as far as investments go.

The key difference between convertible bonds and other types of corporate bonds is that they have the potential for price appreciation. In other words, if the price of the underlying stock that the bond can be converted to rises, the bond’s price can also increase.

How do Convertible Bonds Work?

Here's everything you need to know about convertible bonds.

Like other types of bonds, convertible bonds have set maturity dates and they generally have fixed coupon rates. What makes them different is the conversion option, and each bond has its own conversion ratio. This is the number of shares of common stock the bond can be converted into.

For example, your bond may have a conversion ratio of 20:1. This would mean that one bond could be converted to 20 shares of common stock. Depending on how the bond is structured, its conversion to stock may be optional or mandatory. For example, you may purchase a convertible bond with a fixed date in mind for when you want to convert it to stock. Or, the bond may have its own set date for when a conversion happens, which is typically the maturity date.

The conversion price is set based on the price at which the par value of the bond is equal to the number of converted shares. Typically, when a convertible bond is issued, the per-share price of the underlying stock is less than the conversion price.

A Convertible Bond in Action

Say a company issues a $1,000 convertible bond for stock that’s trading at $50 per share. If you purchase one of those bonds, you would have the opportunity to convert it to 20 shares of common stock in the company. That’s based on the conversion ratio of $1,000 divided by $50.

What happens next, and how much you stand to gain or lose from your investment, depends on how the stock’s price fluctuates. If the stock price were to rise and you converted your shares, you’d be converting for a gain. But if the stock’s price falls, conversion may become less attractive.

Instead of swapping out your bond for common stock in that scenario, you might be better off letting the bond reach its maturity. Then, you could collect your original investment along with any interest earned.

Convertible Bond Pros and Cons

There are several pros associated with investing in convertible bonds, including:

  • Guaranteed income
  • Potentially higher returns than traditional corporate bonds
  • Built-in downside protection

In terms of guaranteed income and downside protection, you’re guaranteed to get your initial investment plus any interest earned returned to you if you don’t convert prior to maturity. The interest can be equated to the dividend payout associated with certain stocks, but you also get the benefit of price appreciation if that stock goes up in value.

That’s chiefly what makes convertible bonds attractive. You have the potential to earn a higher return with these bonds compared to traditional corporate bonds.

However, that’s also the biggest risk factor, or con, with convertible bonds. If the underlying stock underperforms, then you likely won’t see as much growth on your investment.

Another con is the fact that most convertible bonds are callable. This means the company that issued the bonds can force their conversion to stock shares. When that happens, the end result is a cap on your return potential.

How to Invest in Convertible Bonds

Here's everything you need to know about convertible bonds.

Investing in convertible bonds may be a little trickier than purchasing other bonds simply because they’re less common. Not every company issues convertible bonds so it may take some digging to find one to invest in. Many brokerages don’t offer them as a direct investment because they tend to be a bit more complicated than other types of bonds. You may only be able to purchase convertible bonds through a financial advisor or investment advisor that specifically offers these types of fixed-income investments.

There is a work-around, however. You could gain access to convertible bonds by investing in mutual funds, index funds or exchange-traded funds (ETFs) that hold these bonds. These are often readily available through online brokerage accounts.

When assessing which funds to buy, look at the fundamentals of the underlying companies as well as the fees. For instance, ETFs tend to be more cost- and tax-efficient than traditional mutual funds. The trade-off of investing in convertible bonds through a mutual fund or ETF is that you don’t have direct control over which company’s stock you have access. But, this can be an easy way to diversify your portfolio if you’re interested in exploring the return possibilities of convertible bonds.

The Bottom Line

Convertible bonds could offer portfolio growth, but they’re not necessarily right for every investor. Take the time to understand the mechanics of how these bonds work, and how they compare to other types of corporate bonds or investing in stocks directly. It may give you some perspective on what convertible bonds can do for you and your financial situation.

Tips for Bond Investing

  • Whether you’re considering convertible bonds or another type of bond, one important thing to understand is interest-rate risk. Rising or falling interest rates can have a direct impact on bond returns. And bonds with longer or shorter maturities may be more appropriate, depending on which direction bonds are moving.
  • Weigh the benefits of individual bonds versus bond funds or bond ETFs. Bond funds and bond ETFs can offer you exposure to a collection of different bond types in a single investment.
  • If you have more questions about bonds and how they work, consider working with a financial advisor. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.

Photo credit: ©iStock.com/woraput, ©iStock.com/Petar Chernaev, ©iStock.com/tuk69tuk

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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