Reader Question: Convertible Bonds

If you have questions about your finances, you are not alone. In fact, here at Your Finances Simplified we often receive financial questions from our readers.

Larry, for example, has a question about convertible bonds.

I was reading this magazine and came across this thing called convertible bonds. I would like to know is this something good to invest in?

Hi Larry … thanks for your question! For the benefit of readers unfamiliar with convertible bonds, let me begin with a brief definition. Bonds, of course, are loans. These loans have a specified maturity (due) date and interest rate. Convertible bonds are loans to corporations and in addition to having a defined maturity date and interest rate; they afford owners the option to convert the bond to stock, hence the moniker of convertible bond.

Many question the advantages of convertible bonds over dividend stock, arguing that purchasing a blue chip dividend stock is an equally valid investment choice. The flaw in that argument lies in the relative safety of bonds as opposed to stock. You see, bond holders receive preferential treatment in the event of a bankruptcy. Bond holders get paid before stockholders in the event of bankruptcy. As a result, convertible bonds provide appreciation, current income and relative safety for your principal investment. Stock and traditional bonds do not offer all three of these advantages.

Of course, investing in convertible bonds requires all the due diligence associated with selecting a stock. There are no shortcuts here, but you do have a much better chance of preserving your initial principal investment with convertible bonds than you have with an investment in stock.

The convertible bond market is far less volatile, and if you select a solid company that will outlive the maturity date of the bond, your investment is a relatively safe one and not the victim of wild market swings. However, returns on convertible bonds are unlikely to have the upside potential of stock, and they are regarded as a conservative investment by most standards. While the returns won’t be eye-popping—the relative safety of convertible bonds more than compensates for more modest returns in the strategic view of many investors.

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