'Convertible Bond' is explained in detail and with examples in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
A convertible bond is like a hybrid between a stock and a bond. Corporations issue these bonds which the bondholders may choose to convert into shares of the underlying company stock whenever they decide. Such a bond usually pays better yields than do shares of common stocks. Their yields are also typically less than regular corporate bonds pay.
Convertible bonds provide income to their investors just as traditional corporate bonds do. These convertibles also possess the unique ability to gain in price if the stock of the issuing company does well. The reasoning behind this is straightforward. Because the bond has the ability to be directly converted into stock shares, the security’s value will only gain as the stock shares themselves actually rise on the market.
When the stock performs poorly, the investors do not have the ability to convert the convertible bond into shares. They only gain the yield as a return on the investment in this case. The advantage these bonds have over the company stock in these deteriorating conditions is significant.
The value of the convertible instrument will only drop to its par value as long as the company that issues it does not go bankrupt. This is because on the specified maturity date, investors will obtain back their original principal. It is quite correct to say that these types of bonds typically have far less downside potential than do shares of common stocks.
There are disadvantages as well as advantages to these convertible bonds. Should the issuer of the bond file for bankruptcy, investors in these kinds of bonds possess a lower priority claim on the assets of the corporation than do those who invested in debt which was not convertible. Should the issuer default or not make an interest or principal payment according to schedule, the convertibles will likely suffer more than a regular corporate bond would. This is the flip side to the higher potential to appreciate which convertibles famously possess. It is a good reason that individuals who choose to invest in single convertible securities should engage in significant and extended research on the issuer’s credit.
It is also important to note that the majority of these convertible bonds can be called. This gives the issuer the right to call away the bonds at a set share price. It limits the maximum gain an investor can realize even if the stock significantly outperforms. This means that a convertible security will rarely offer the identical unlimited gain possibilities which common stocks can.
If investors are determined to do the necessary research on an individual company, they can purchase a convertible bond from a broker. For better convertible diversification, there are numerous mutual funds which invest in only convertible securities. These funds are provided by a variety of major mutual fund companies.
Some of the biggest are Franklin Convertible Securities, Vanguard Convertible Securities, Fidelity Convertible Securities, and Calamos Convertible A. Several ETF exchange traded funds provide a similar convertible diversification with lower service charges. Among these are the SPDR Barclays Capital Convertible Bond ETF and the PowerShares Convertible Securities Portfolio.
It is important to know that the bigger convertible securities portfolios such as the ETFs track have a tendency to match the performance of the stock market quite closely in time. This makes them similar to a high dividend equity fund. Such investments do offer possible upside and diversification when measured against typical holdings of bonds. They do not really offer much in the way of diversification for individuals who already keep most of their investment dollars in stocks.