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, a company that has 10 million shares of stock outstanding that sells an additional 1 million shares 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 at 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 collected 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.)
Other times, convertible bonds are issued with a conversion ratio. If the bond has a 10-to-1 conversion ratio, that would mean one $1,000 bond would convert to 10 shares of the stock at $100 per share.
Similar to the premium option, if the stock was trading below $100, the bondholder could elect to simply receive their $1,000 back at maturity. If the stock is trading above $100, they can convert to equity and have an immediate profit.
Because of the lower interest rates and the desire to not dilute shareholders when stocks were already plummeting during the COVID-19 crash, new issues of convertible bonds are at a 12-year high.
In April, companies issued $14 billion of convertible debt , and they’ve issued $10 billion already this month as of May 13.
Cruise operator Carnival (NYSE: CCL) was able to save a bundle in interest by issuing $2 billion in debt with a 5.75% interest rate. That’s half of the 11.5% it’s paying on regular debt.
Convertible bonds typically outperform both stocks and bonds, especially in volatile periods. This is not surprising since they participate in the upside of stocks with the safety of bonds.
Over the past year, the SPDR Bloomberg Barclays Convertible Securities ETF (NYSE: CWB), the largest convertible bond exchange-traded fund (ETF), outperformed the stock market significantly. While the S&P 500 gained 2.3%, the ETF climbed 7.4%.
And during the recent crash in February and March, while the ETF fell along with every other asset, its 10.9% drop from February 19 to May 13 was far less than the 16.3% fall of the S&P 500.
The SPDR Bloomberg Barclays Convertible Securities ETF currently yields 3.2%. Its largest holdings are convertible bonds from Wells Fargo (NYSE: WFC), Tesla (Nasdaq: TSLA) and Bank of America (NYSE: BAC).
I don’t recommend buying the ETF because while it may outperform the market, investors won’t enjoy the benefits of owning individual convertible bonds.
And those benefits are crucial. They allow investors both the opportunity to profit when stock prices rise and the near guarantee of getting their money back when stock prices fall.
With an ETF, the value is tied to the value of the bond portfolio, which may fall. I’m mentioning this ETF only to show you that convertible bonds outperform the market.
Convertible bonds may be one of the best kept secrets in the market due to their safety and ability to appreciate in price. Both attributes have never been more important.