You want the returns of a stock, but you also want downside protection. This might seem like a difficult conundrum, but there may be an easy answer. A convertible bond is indeed a bond, but it converts to equity at a predetermined maturity date. The number of shares is set in the conversion ratio, which is fixed when the bond is issued. (For more, see: The Wonders of Convertible Bonds.)

For example, a company issues a convertible with a five-year maturity at 5%, and a conversion ratio of 50. That means each $1,000 bond is worth 50 shares of the company's stock. At the end of five years, one of two things happens:

  1. If the stock price languishes and stays below $20, the investors would get the principal plus interest of $1,050. (This assumes the bonds sold at par). Investors get a predictable return in that case, whatever happens to the stock or to stock markets generally.
  2. If the price of the stock goes above $20.40, the investors would be more likely to convert the bond to shares, as a $1,000 investment would then yield at least $1,050. A $30 stock price at maturity would net an investor $1,500, assuming they sold it immediately.

Note that the bond-like behavior protects from downside risk. Investors have a minimum guaranteed return (provided the issuer doesn't default). In a bear market the fact that the principal is protected can mean a lot. (For more, see: Convertible Bonds: Pros, Cons for Companies and Investors.)

As the price of a convertible bond approaches the break-even point, the price of the bond can rise as investors pay a premium on them. In the above example, if the stock reached $30 before the convertible matured, then the price of the convertible might well reach $1,500, assuming investors were bullish on the equity.

The hybrid features of convertibles make them attractive to investors looking to hedge risk, which is evident when looking at a chart of the SPDR Barclays Capital Convertible Securities ETF (CWB). The exchange-traded fund tracks the Barclays U.S. Convertible Bond >$500MM Index, which covers bonds with an outstanding issue size of more than $500 million and more than 31 days until maturity.

(Source: Google Finance)

Note that the CWB curve is relatively flat compared with the Dow Jones Industrial Average and S&P 500 Index. The dips are muted but the peaks are also. That might look and sound too good to be true, so it's also important to outline the downside of convertibles and convertibles funds as well. (For more, see: Leverage Your Returns with a Convertible Hedge.)

Drawbacks

On of the downsides is that convertibles funds tend to have higher expense ratios. For example, the Vanguard Convertible Securities Fund (VCVSX) carries an expense ratio of 0.41%, a good deal higher than most of the firm's offerings and comparable to its other actively managed funds. The AllianzGI Convertible Fund A (ANZAX) costs investors 0.97%. An S&P-tracking ETF like the SPDR S&P 500 ETF Trust (SPY) comes in at 0.1%. (For more, see: Pay Attention to Your Fund’s Expense Ratio.)

It's also questionable that such funds are that good as a hedge. "They tend to be more closely correlated to the stock market than conventional bond funds are, making them generally less useful as a diversifier," said Mike Piper, CPA and author of several books on personal finance. He said altering the bond-stock allocation in a portfolio is probably good enough for most people without the added complexity. (For more, see: A Strategy for Optimal Stock, Bond Allocation.)

Another issue is yield. Most convertible coupon rates (and corresponding yields) are lower than for traditional bonds. That's because there's value in converting to equity, and the interest rate reflects that.

For example, Twitter, Inc. (TWTR) issued a convertible bond, raising $1.8 billion in September 2014. The notes were in two tranches, a five-year due in 2019 with a 0.25% interest rate, and a seven-year due in 2021 at 1%. The conversion rate is 12.8793 shares per $1,000, which at the time was about $77.64 per share. The price of the stock has ranged between $35 and $56 over the last year. To make a profit on the conversion, one would have to see the stock more than double from the $35-$40 range where it has spent the last two months. The stock certainly could double in short order, but clearly it's a volatile ride. And given a low-interest rate environment, the principal protection isn't worth as much as it might otherwise be. (For related reading, see: How Does Twitter Make Money?)

Note also that the bonds in a convertible will often be low investment grade or even below that – that's part of the reason some companies tap the convertible market in the first place. (For more, see: What Does Investment Grade Mean?)

What about investing in individual convertible bonds? Piper notes that in that case you have a risk in the individual security, called diversifiable risk – that is, it's risk that isn't rewarded because it isn't systematic. The other problem for individual retail investors is that figuring out how to price a convertible is difficult. (For more, see: Risk and Diversification: The Risk-Reward Tradeoff.)

"In order to accurately determine whether a convertible bond is mispriced, you would have to determine the true value for a bond, a call option on the stock, and potentially a call option on the bond. There very well may be some individual investors who are better than the market at determining those two to three values, but surely such investors are few and far between. I am certainly not one of them myself," he said.

Another risk to upside is that issuers can force conversions. If an issuer decides its stock price has risen too high (or is likely to rise further), or if interest rates decline, then it might decide to force investors to take the equity at the conversion price. Investors lose any upside gain in this case.

Lastly, there's the fact that convertibles as a whole is a small market. In the U.S. the total is about $250 billion, worldwide it might be $500 billion, according to a 2014 white paper by Ernst & Young. That means whatever a single issuer does can have an outsized effect on the market as a whole – and on funds that invest in convertibles.

This is also one reason that the biggest investors in convertibles tend to be institutions. While there are a number of funds offered by major investment firms, the kind of hedging that convertibles offer is often more significant for larger accounts. That said, there has been an uptick in the popularity of convertible bond funds, largely because even after nearly a decade there's a not-insignificant number of investors who were frightened off of straight stocks. (For more, see: These Bond Funds Act Like Stocks.)

The Bottom Line

Convertibles are a good hedge against equity risks, if one is happy with losing a bit of upside potential. But for some it might be simpler to just alter allocations between bonds and stocks. (For more, see: The Mandatory Convertible: A 'Must Have' for your Portfolio?)

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