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Convertible Bonds: An Investor's Best Friend, Part 1

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All the upside, but better downside protection.

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Editor's Note: Bill Feingold has been a convertible portfolio manager, trader and analyst for 15 years and has taught and written about convertibles and options. He is a summa cum laude economics graduate of Yale and received an MBA with distinction in finance from Wharton. This is his first article for Minyanville.

This is Part 1 of a 2-part article. Part 2 can be found here.


Converts Before the Fall

What would you say if someone offered you a chance to invest in stocks with virtually all the upside -- in some cases, more than all the upside -- but far better downside protection? What if the opportunity has arisen only because of certain recent events that may never happen again?

You are about to learn about convertible bonds, and why, more than ever, they give you a better way of buying many stocks.

What Are Convertible Bonds?


Convertible bonds (or, as I will refer to them, "converts") are simply corporate bonds that give investors the right to convert the bonds into stock. Essentially, when you buy convertible bonds you can get the best of both worlds-the current income and assurance of principal repayment that come with bonds, the upside potential of stocks.

Let's take a hypothetical example. XYZ Company's stock is trading at $80 per share. To raise money for expansion, XYZ issues a convertible bond at $100 per unit. It pays a 4% annual interest rate (or "coupon") and matures in 5 years.

So far, this is like any other bond. But here's the difference: The convertible feature dictates that you have the right to convert your unit into one share of stock. Suppose in 5 years, when the bonds mature, XYZ stock is trading at $160. You will have the choice: Let the company give you $100, according to its contractual obligation, or convert your unit into a share of stock worth $160. Which would you choose?

If you said you would convert into stock, congratulations. If not, ask yourself why you would prefer $100 to $160!

Now, suppose the stock in 5 years has gone from $80 to $20. You can either take the $100 from the company, or convert into a share of stock worth $20. Which would you choose this time?

Correct. With a big sigh of relief, you get back your $100, and move on.

So, when the stock doubles (a 100% return), you make a 60% return on a convertible bond that goes from $100 to $160. But you actually do even better, because you have been collecting a 4% coupon every year for 5 years, giving you an extra 20% over the period on your investment. You made 80% on the convertible - you participated in 80% of the stock's upside, assuming that the stock was not paying any dividends.

But when the stock loses much of its value -- 75% in the example above -- you still get all your money back, along with the 20% accumulated interest. You make money even as the stock gets decimated.

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No positions in stocks mentioned.

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