When building a portfolio investors need to consider a wide range of asset classes including convertible securities. A convertible security is usually a bond or a preferred stock that can be converted into shares of the issuing company's common stock. Generally, the owner of the convertible determines if and when to convert, but in some cases the company has the right to determine when the conversion occurs.

Relative to the stock and bond markets, convertibles securities are a small, specialized niche. Prices vary based on market conditions as well as supply and demand. Companies issue convertible securities to quickly raise money and the rating of the security is based on the financial stability of the issuing company. Many convertibles are issued by companies that might otherwise have difficulty with a more traditional stock or bond offering. These securities tend to have a below investment grade bond rating. Thus, to attract investors, securities offerings by companies with low financial ratings usually pay a higher rate of interest and have more favorable terms of conversion. (For related reading, see: The Workings of Equity Portfolio Management.)

How Does the Conversion Work?

Most convertible securities have a fixed conversion formula. For example, a $1,000 convertible bond is issued with a 1.5% interest rate when the company’s stock is trading at $10. The owner of the bond has the right to convert the bond into 50 shares of the company’s common stock when the price is at or above $20. However, some convertibles are issued with a conversion ratio based on fluctuating market prices. This strategy helps the company manage the timing and number of shares of common stock that have to be issued.

How to Buy Convertibles

Individual convertible securities can be purchased, however it’s really not an efficient market and difficult for small investors to obtain optimal pricing. Generally, it’s best to buy an open or closed end mutual fund that provides active management. There are also convertible exchange traded funds and some equity funds managers include convertibles in their portfolios. (For more, see also: An Introduction to Closed End Funds.)

Convertibles in which the issuing company’s stock is not trading at or above the prescribed conversion price tend to be priced and trade more like a bond. These are sometimes called busted convertibles. Once the price of the company’s stock has hit or exceeded the conversion price the securities tend to behave more like an equity and trade in line with the issuing company's stock price. Between busted and equity are balanced convertibles which have some equity risk that is tempered by the interest payment.

The risk and return of an open or closed end fund depends on the actual securities the manager holds in the portfolio. Some funds only invest in the U.S., while others hold securities from around the world. Also, many closed end funds, which may trade at a discount, have an appealing higher yield since managers leverage their portfolios by up to 30%. But in exchange, these funds have greater risk since their price will fluctuate with changes in interest rates. 

How to Use Convertibles in Your Portfolio

The return of a convertible fund tends to follow the equity, rather than the bond market. According to Morningstar, the average open end convertible fund lost about 33% in the 2008 market crash as compared to the S&P 500 which lost 37%. However, when the markets rebounded in 2009 and 2010 convertible funds were up about 41% and 17% outperforming the S&P 500 which had returns of about 26% and 15%.

Historically, convertible security funds have had a high correlation with equities and a negative correlation with U.S. Treasuries.In a portfolio convertibles tend to behave like high yield corporate bonds. An allocation of 3–5% of your portfolio can provide income as well as help manage some of equity risk and reduce volatility.  

The Bottom Line

As a hybrid security, convertibles can help diversify your portfolio and offer potential for higher returns that is tempered by the income from the bond.

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