As an investor, you may come across various investment opportunities that you are unfamiliar with over the years. Taking time to learn more about them can help you make savvier financial decisions. Hopefully, it can help you generate growth in your portfolio over the years. One investment option that many investors are relatively unfamiliar with is a convertible bond. You may be wondering what is a convertible bond and how can it help you improve your financial standing. When you ask what is a convertible bond, the answer will help to better determine if and when you should add this type of investment to your portfolio.
The Concept of a Convertible Bond
If you want to know what is a convertible bond, you need to understand when businesses would issue these bonds. When a company needs to raise funds, it can issue stock. However, issuing stock can be a negative sign to investors.
For example, it could signal to investors that the stock price is overvalued. Issuing a convertible bond is an alternative way for companies to raise capital without the negative perception. If a company performs well in the future, bondholders can convert the funds to equity at a later date.
With a convertible bond, investors are able to buy the bonds in the same fashion as they would any other type of bond. The company will use the funds for any type of project that it needs to. If the project fails, the investor’s initial investment is safe.
However, if the company enjoys incredible growth from the venture or project, the bond can convert to equity. The investor can gain financially. In this way, both the company and the investor can benefit from participating in a convertible bond venture.
Essentially, a convertible bond is a type of bond that can pay the investor a certain rate of return until the bond matures. This safe rate of return is typically nominal or modest. However, the bond also has a call option available on it. The investor can exercise it at his or her discretion. This call option converts the bond into company stock. It is most commonly in exercise when the company’s stock price increases to advantageous levels for the investor.
Advantages and Disadvantages of Convertible Bonds
After you have learned what is a convertible bond, you are understandably impressed with how they work. You may also be eager to find convertible bonds to invest in. However, before you jump head first into this type of investment, you should learn more about their advantages and disadvantages.
Advantages of a Convertible Bond
There are significant advantages in relation to convertible bonds that savvy investors can benefit from. By asking what is a convertible bond, you will learn the following. An investor’s risk is mitigated with this type of investment while his or her return can be incredible. The funds are invested initially as a low-risk bond with a specified and usually low rate of return.
Convertible bonds come with a stated conversion ratio. This means that the number of shares that the bond can be converted to if the investor exercises this option is predetermined by the company. The investor knows exactly what the upside potential is if the company’s stock price increases during the bond’s term length. He also knows when to properly make a conversion to maximize return on investment. It is up to the investor to exercise this option in most cases.
Many investors want to enjoy the upside associated with investing in the stock market. However, they oppose the possible risk in association with a decline in stock prices. Convertible bonds offer a modest guaranteed return. The investor does not have to convert the bond into stock if the stock price is not doing well.
This ability to enjoy a modest profit while having the opportunity convert the bond into company stock and to enjoy an incredible return is beneficial. It essentially gives the investor the best of both worlds within a single investment vehicle. You should be aware that there are also ETFs that trade in convertible bonds. Let’s say you are looking for a truly simple way to invest in these bonds with a hands-free option. Then this type of professionally managed ETF may be ideal for you.
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Disadvantages of a Convertible Bond
As amazing as a convertible bond may sound, there are some significant drawbacks associated with them as well. When asking what is a convertible bond, it is important to look at all aspects of this investment vehicle before you make an investment decision.
For example, because of the nature of convertible bonds, they have a close link to the stock market. Many investors purchase traditional bonds as a hedge against inflation. That’s when there may be more volatility in the economy. However, these bonds are not necessarily a good investment for that purpose.
In addition, when you compare the fees of convertible funds against those of traditional funds, they are much higher. Higher fees with your investments can eat away at your overall return. When investing in convertible funds, ensure that you understand all aspects of the pricing before you make a purchase.
If you worry about getting a guaranteed minimum rate of growth from bonds, take note of this. The yield on convertible bonds is usually much lower than with traditional bonds. In addition, the conversion rate may not be as high as you might think. The reality is that many companies set the conversion rate in their favor. In fact, in some cases, stock prices would have to more than double in order for investors to profit from a stock conversion.
Furthermore, convertible stocks have a higher risk or lower grade investments. These options are usually not available with the top companies that you may want to add to your stock portfolio.
Companies also have the right to force a conversion of the bond into stocks. This most often happens when the stock price rises too high. If so, investors may lose money by converting to the stock at an undesirable price.
To fully profit from the maximum potential of a convertible bond, you must regularly monitor stock prices. Be prepared to act on the conversion at the ideal time. If you do not time the conversion properly, you may not profit as significantly from your investment as you otherwise could have. With this in mind, this type of investment requires ample time to regularly monitor prices.
As you can see, there are significant benefits associated with investing in a convertible bond as well as many drawbacks. After you have asked what is a convertible bond, you may be able to see more clearly how you can use them to enhance your portfolio. You can determine if this is a type of investment vehicle you want. If you have personal experiences with these bonds or if you want to provide others with information about what is a convertible bond, please leave a comment below.
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