Investors who seek higher yields have been scrambling to find offerings that fit their objectives for the past few years. One asset class that may be a good choice for many of them is convertible bonds. These unique instruments can provide competitive yields with the upside potential of common stock, and they may make sense for investors who are looking to get a better return on their fixed-income investments. Here’s how these bonds work and why this may be the time to get into them.

How They Work

Convertible bonds are hybrid securities. They come in the form of a bond that can be converted into a preset number of shares of the issuer’s common stock, or a number of shares at a given share price. However, they are still guaranteed by the issuer for interest and principal, so they have the safety of a bond with the upside potential of stock. (For more, see: Convertible Bonds: An Introduction.)

Different bond issues come with different conversion ratios. The ratios also change with stock splits and stock dividends. Because of their conversion feature, most convertible bonds will pay a slightly lower yield than other types of bonds. But their value will rise if the value of the company’s stock rises. If the value of the stock falls to a point that makes the conversion feature worthless, then the bond price will be based upon its yield as with any other bond. Convertible bonds are currently yielding about 3.5%, and they represent an attractive way to get into the market because of their defensive nature.

Boris Schlossberg of BK Asset Management told CNBC in an interview that the worst case scenario is that you simply get your principal back plus a little interest, and the best case scenario is that if the stock goes up, then you have a chance to appreciate on the equity side as well.

Edward Silverstein, head of the Convertible Bond team at MacKay Shields, stated back in October of 2015 that this was and still is a good time to get into convertible bonds. “Strong returns by convertible bonds over the past two years support the notion that convertibles should outperform in a rising rate environment and, unlike nearly all other classes of fixed income instruments, have almost no correlation to the movement in interest rates. We believe this trend will continue as long as the economy remains in recovery mode. Given the slowly improving macro economy and the relatively low rates of interest and inflation, stocks appear inexpensive based on various measures such as price to earnings, price to cash flow or price to free cash flow. As such, we expect convertible bond and stock prices to move higher in the coming 12 to 18 months.” (For more, see: The Wonders of Convertible Bonds.)

Convertible bonds tend to perform more like stocks when the markets are going up and more like bonds when they decline. But they are less likely to be sold in a panic during severe bear markets because of their principal guarantee and they will pay interest until they are converted. Most convertible offerings are issued by very stable companies, so their default rate is very low. Investors who are looking to get into this asset class may want to look at exchange-traded fund (ETF) SPDR Barclays Convertible Securities ETF (CWB) that invests in a broad index of convertible issues and offers transparency, liquidity and low fees.

The Bottom Line

The convertible bond market is relatively small compared to other types of bonds, so a surge in demand for these securities will also lead to a surge in price. But convertible bonds offer a competitive rate of return in what is a very, very tough market right now. (For more, see: 3 Best High-Yielding Convertible Bond ETFs.)

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