Pros and Cons of Convertible Bonds

Some corporate bond issuers sell bonds that can be converted into a fixed number of shares of common stock. With a convertible bond, a lender (bondholder) can become a part owner (stockholder) of the company by converting the bond into company stock.

Having this conversion option is a desirable thing (options are always desirable, no?), and so convertible bonds generally pay lower interest rates than do similar bonds that are not convertible.

If the stock performs poorly, then there is no conversion. You are stuck with your bond’s lower return (lower than what a nonconvertible corporate bond would get). If the stock performs well, there is a conversion. So you win, so to speak.

Know this: Convertible bonds, which are fairly common among corporate bonds, introduce a certain measure of unpredictability into a portfolio. Perhaps the most important investment decision you can make is how to divide your portfolio between stocks and bonds.

With convertibles, whatever careful allotment you come up with can be changed overnight. Your bonds suddenly become stocks. You are rewarded for making a good investment. But just as soon as you receive that reward, your portfolio becomes riskier. It’s the old trade-off in action.

While convertible bonds are not necessarily horrible investments, they may not deserve a very sizeable allotment in most individuals’ portfolios.

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