File photo by Andrii Yalanskyi / iStock / Getty Images Plus, St. George News
SPECIAL FEATURE –Beginning in 2020, the Federal Reserve cut rates to their lowest level in decades, slashing the 10-year Treasury rate from a robust 2% to 0.5%. That sharp decline was a blow to savers, especially those who traditionally have relied on bonds as a safety anchor for their bond portfolios.
File photo by wutwhanfoto / iStock / Getty Images Plus, St. George News
Since 10-year treasury rates determine about half of the return on corporate bonds, convertibles are also feeling the sting of almost negative interest rates.
Discouraged by a cool bond market, many who count on bonds for retirement income are looking to convertible bonds as an alternative. Corporate bonds, which can be exchanged for common stock of the issuing company, convertible bonds can lower the coupon rate on debt, thus saving the interest on the company.
Convertible bonds allow a holder to exchange them for a predetermined number of common shares of the issuing company. Convertible bonds work much like traditional corporate bonds, but with slightly lower interest rates.
Because convertibles can be converted into stocks and benefit when the underlying stock price rises, companies offer lower returns. If the underlying stock does not perform well, conversion will not take place and the investor will be stuck with the below-average yields on the bond.
How do convertibles work?
File photo from Unsplash, St. George News
Convertible bonds operate according to the so-called “conversion ratio”. This formula determines how many shares will be converted from each bond. The conversion ratio is expressed either as a ratio or as a conversion price.
For example, if the conversion ratio is 40: 1 with a face value of $ 1,000, shareholders can convert the bond into 40 shares in the issuing company.
The convertible bond price begins to rise when the company’s share price approaches the conversion price. In this case, your convertible will act much like a stock option. If the company stock is experiencing volatility, so will your bond.
Why would anyone consider adding convertible bonds to their portfolio?
Investors add convertibles to their investment mix as convertibles offer guaranteed returns with built-in loss protection. If an investor does not convert before the due date, he will get his original investment back plus the interest earned. There is also the potential for higher returns than traditional bonds.
What are the pitfalls of convertible bonds?
The “forced conversion” element of a convertible bond is one of the major drawbacks of these instruments. The issuer of the bond reserves the right to force investors to convert the bonds into stocks. Such a conversion usually takes place when the share price is higher than the amount that would be the case if the bond were repaid.
A certain type of convertible bond, called reverse convertible bonds, enables the issuing company to convert the bond into shares or hold it as a fixed income investment until maturity. These bonds, unlike common stocks, can limit the capital appreciation of the bond. Such caps mean that the basic protective element of these bonds may not be as worthwhile as it first appears.
In summary
Convertibles are somewhat complicated instruments designed to deliver guaranteed returns while protecting against market losses. Companies typically issue convertible bonds with less than exceptional credit ratings but with high growth expectations. Convertible bonds allow these companies to raise money to expand at a much lower cost than traditional bonds.
When considering buying a convertible bond, you need to understand the basics of how it works and all of the risks involved.
Always consult an authorized and licensed financial professional to clarify the pros and cons of convertibles in relation to your situation and risk tolerance. Your advisor can suggest other products, such as Fixed Indexed Annuities, which also guarantee a principle with growth potential.
Copyright © Lyle Boss, all rights reserved.
Lyle Boss is a member of Syndicated Columnists, a national organization that advocates a fully transparent approach to money management. As an asset protection instructor, he has helped thousands of seniors find their financial retirement options. Its clients include government employees, teachers, doctors, farmers and business people, to name a few. Boss has been actively teaching advanced estate planning and wealth preservation for more than 20 years in locations like the University of Utah and in over 200 Senior Retirement Consumer Education Workshops throughout Utah, Idaho, and Wyoming. Boss and his wife Deanna live in South Ogden and St. George, Utah.
Comments are closed.