How do I use a premium put convertible?

By Justin Bynum AAA
A:

Holders of convertible bonds

face all the pitfalls that traditional bondholders face - liquidity risk, interest rate risk and default risk. But, there is one important difference: convertible bondholders also risk loss of principal due to declines in a company's underlying stock price. Granted, because the price of a convertible bond is closely tied to the price of the underlying equity, the potential for price appreciation is also much greater. However, given bond investors' preference for income first, price appreciation second - and price depreciation never - how can individual convertible bond investors protect themselves?

Enter the premium put convertible. Just like an option, the premium put allows the bondholder to put the bond back to the issuer at a premium before the bond reaches maturity. For this reason, the premium put feature has two distinct advantages over "standard issue" convertible bonds:

  1. Should the value of the underlying stock decline, the bondholder simply can redeem the bond at face value, plus the premium; and
  2. If interest rates rise, the bondholder has the option of redeeming the bonds and lending the proceeds at a higher rate.

Of course, the premium put convertible comes with a price. Almost always, the stated interest rate of the bond is less - sometimes significantly so - than that for a "standard issue" convertible bond.

For more on convertible bonds, read Convertible Bonds: An Introduction.

This question was answered by Justin Bynum.

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