Some bonds can be converted into a predetermined number of shares of common stocks of their issuing companies. These are called convertible bonds, and they represent one of the different types of bonds based on embedded options and an example of a hybrid security.
These bonds can appeal to certain investors who are also predisposed to leaning toward stock investing. However, despite their flexibility, these bonds have drawbacks. This article discusses the advantages and disadvantages of convertible bonds.
Pros: Advantages of Convertible Bonds
Convertible bonds offer investors the potential to benefit from both the fixed-income nature of bonds and the potential for capital appreciation of stocks. The conversion option specifically allows investors to maximize the potential of their investments during periods of favorable growth in the stock market or the specific issuing companies.
Furthermore, despite offering lower coupon rates and yields than callable bonds and traditional bonds, purchasing and owning these bonds can be an attractive option for investors seeking a balance between passive income generation and wealth accumulation. The following are the specific advantages of investing in convertible bonds:
• Flexible Investment Vehicle: Purchasing and holding convertible bonds afford investors flexibility from the conversion option. Remember that these bonds are one of the examples of hybrid security. Bondholders have the option to remain invested in these bonds and later decide to become common stockholders once converted into shares of stocks of the issuing companies.
• Has Downside Protection: These bonds might have lower yields compared to traditional bonds but they also have the potential for upside participation in the stock market. Furthermore, because these bonds are still debt securities, they offer investors downside protection in case the stock price does not increase as expected. These facts highlight the flexibility of convertible bonds.
• Income or Capital Appreciation: Convertible bonds also provide investors with an option between passive income generation or sizeable capital appreciation. Retaining these bonds is ideal for income-seeking investors. However, because they can be converted into shares, they are also ideal for investors who might lean toward a more aggressive capital-appreciation investment vehicle.
• Diversification of Portfolio: Another advantage of convertible bonds is that adding them to an investment portfolio can provide diversification benefits. These bonds expose their investors to both the bond market and the stock market. Diversification is essential in reducing portfolio risk and exposure to market volatilities.
Cons: Disadvantages of Convertible Bonds
These bonds are not ideal for investors who want to have higher returns while remaining invested in the bond market. Bonds have risks but they collectively remain an ideal investment vehicle for investors with moderate to conservative risk profiles. Those who want better returns should invest instead in callable and traditional investment-grade bonds.
Converting these bonds into shares of stocks would also mean exposing the investors to the inherent risks in stock investing. Remember that stocks are ideal for investors with a higher risk tolerance. The conversion option is not suitable in several cases. Below are the specific disadvantages of investing in convertible bonds:
• Some Have a Call Option: Investors need to be aware of the options embedded in convertible bonds because some have both a conversion option and a call option. A call option exposes bondholders to call risk. This risk comes from the fact that these bonds can be redeemed by their issuers. Forced redemption can result in bondholders becoming too liquid or unable to find similar investments.
• Forced Stock Conversion: Another disadvantage of convertible bonds is the specific call option that grants their issuers the right to force bondholders to convert them into shares of stocks. This can limit the potential for capital appreciation if interest rates fall. Investors need to be aware of the associated terms and conditions.
• Downside of Stock Conversion: Converting these bonds into shares of common stocks exposes investors to the risks of stock investing. Remember that stocks are riskier investments than bonds. It is also important to note that conversion would result in bondholders losing their right to interest payments and principal.
• Limited Upside Potential: It is true that these bonds offer potential upside through stock conversion. But this potential is limited by the conversion ratio and the current stock price. For example, during bullish periods in the stock market, the stock prices of the issuing companies might rise significantly, thus the convertible bonds would end up being converted into a limited number of shares.