What Is It?
A convertible, sometimes called a CV, is either a convertible bond or a preferred stock convertible. A convertible bond is a bond that can be converted into the company's common stock. You can exercise the convertible bond and exchange the bond into a predetermined amount of shares in the company. The conversion ratio can vary from bond to bond. You can find the terms of the convertible, such as the exact number of shares or the method of determining how many shares the bond is converted into, in the indenture. For example, a conversion ratio of 40:1 means that every bond (with a $1,000 par value) you hold can be exchanged for 40 shares of stock. Occasionally, the indenture might have a provision that states the conversion ratio will change through the years, but this is rare.

Convertibles typically offer a lower yield than regular bonds because there is the option to convert the shares into stock and collect the capital gain. However, should the company go bankrupt, convertibles are ranked the same as regular bonds, so you have a better chance of getting some of your money back than those people holding common stock. (To learn more, see Convertible Bonds: An Introduction.)

Objectives and Risks
Convertibles are an excellent choice for investors looking for capital appreciation, while still protecting their original investment in a bond. While CVs do provide some income, it's not very high. Investors give up higher returns on the bond in exchange for the option to convert into shares at a later date.

One risk associated with convertibles is that most are callable. In other words, the company can force convertible bondholders to convert the bonds to common stock by calling the bonds. This is called "forced conversion". When investing in convertibles, remember that the CV is only as good as the underlying stock, and if the CV is offering a high premium, be very wary.

How to Buy or Sell It

The most common method for buying stocks is to use a brokerage, either full service or discount. The minimum investment for a convertible is typically $1,000 - the price of one bond. Convertible preferred stock trades on the stock market like regular shares, so the prices usually range from $5 to around $100.



Strengths
  • Your original investment cannot go lower than the market value of the bond; it doesn\'t matter what the stock price does until you convert into stock.
  • Convertibles can be purchased through tax-deferred retirement accounts.
  • CVs gain popularity in times of uncertainty, when interest rates are high and stock prices are low. This is the best time to buy a convertible.

  • Weaknesses
  • The return on the bond or preferred stock is usually quite low.
  • "Forced conversion" means the company can make you convert your bond into stock at virtually any time. Pay very close attention to the price at which the bonds are callable.
  • Three Main Uses
  • Capital Appreciation
  • Safe Investment
  • Tax-Deferred Investment

  • Next: 20 Investments: Corporate Bond »



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