Stocks Or Bonds? Try The Best Of Both Worlds

Stock investors have the opportunity to make considerable profits, but they have to take on risk in order to achieve those profits. Bond investors typically don’t have much upside, but instead they earn steady income with a high degree of safety.

But, there is a little-talked-about investment that allows you to participate in a rising stock price with the safety of a bond.

Convertible bonds are bonds that can be swapped for stock if the stock price has gone up. Alternatively, they can be kept as a bond until maturity, ensuring the bondholder gets their money back even if the stock falls.

Here’s how it works:

When a company issues a convertible bond, it usually can do it at a lower interest rate than a regular bond, saving the company money on interest payments. Additionally, because it is not selling stock immediately, there is no perception of dilution. Dilution occurs when a company sells more stock.

For example, if a company that has 10 million shares of stock outstanding sells an additional 1 million shares, this action dilutes existing shareholders by 10% because there are now 10% more shares outstanding. When the company sells the stock, a press release is usually issued, and the entire market knows that the company just diluted its shareholders by 10%.

However, if convertible bondholders convert their bonds to shares, no such announcement is made. And not every bondholder will choose to convert their bonds to stock. Convertible bonds are issued either at a premium or a specified conversion ratio.

For example, a company with a stock trading at $40 may issue a convertible bond with a 25% premium. That means the bondholder can convert the bond to shares at a 25% premium to the stock price when the bond is issued – in this case, $50 a share.

If, at maturity, the stock is trading above $50, convertible bondholders immediately see a profit in their shares (and they collect interest income before converting). If the stock is trading below $50, they don’t have to convert, and instead can get their $1,000 per bond at maturity. (Most bonds are issued at $1,000 par value. Investors may pay more or less than $1,000 when they buy them in the open market. But, at maturity, bondholders receive $1,000 per bond.)

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