Convertible Vs. Nonconvertible Bonds

Convertible bonds can provide significant returns when the company's stock price increases.

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While traditional stocks and nonconvertible bonds make up the majority of most portfolios, they're not the only savings vehicles available to investors. Convertible bonds are an ideal compromise between the two, offering the higher returns commonly found with stocks along with the reduced risk associated with bonds. These lesser-known bonds offer greater choice and flexibility than nonconvertible bonds for investors who prefer greater control over their investments.

Definition

Corporations have long used nonconvertible bonds to secure financing for new equipment, expansions and other needs. When investors purchase nonconvertible bonds, they agree to lend the company money for a specified time in return for a set interest payment. For example, an investor could purchase a $10,000 bond at 10 percent for 10 years. Each year, he would receive 10 percent of the bond value in the form of an interest payment, and at the end of the 10 years, he would receive his $10,000 investment back. Convertible bonds work in a similar fashion and feature an interest rate and a specified loan period. They differ from traditional bonds in one important way, however; investors who hold convertible bonds have the option to trade the bond in for shares of company stock. The bond will specify a conversion ratio that explains how many shares of stock the bond can be converted into, as well as the pre-set purchase price for the stock. The investor is not obligated to convert the bond into stocks but may do so at his own choosing.

Pros and Cons of Nonconvertible Bonds

Nonconvertible bonds have long been recognized as a stable way to grow savings without the volatility associated with the stock market. The biggest drawback to bonds is their lower interest rate compared to stocks, as investors are forced to settle for a lower return in exchange for lower risk. Bonds returned an average of 6.48 percent over the 50 years from 1959 to 2008, while stocks returned 9.18 percent in the same period, according to Russell Investments.

Pros and Cons of Convertible Bonds

The primary advantage of a convertible bond is that it typically offers a better return than a traditional bond without the added risk of the stock market. According to Kiplinger, the return on a convertible bond generally falls between that of bonds and stocks. This higher return comes from the earnings investors gain when the company stock price rises and they trade their bond in for shares of stock. It also comes from the dividends associated with those shares. At face value, the interest rate on a convertible bond is actually lower than that found on nonconvertible bonds. Investors are willing to accept this lower interest rate in exchange for greater flexibility to transform the bond into shares of stock and for the potential to earn more if stock prices rise.

Considerations

Kiplinger suggests that investors consider putting 5 to 10 percent of investment savings into convertible bonds while keeping the rest in traditional stocks and bonds.

Photo Credits

  • Penny Stock Rainbow image by Magical Art from Fotolia.com

About the Author

Emily Beach works in the commercial construction industry in Maryland. She received her LEED accreditation from the U.S. Green Building Council in 2008 and is in the process of working towards an Architectural Hardware Consultant certification from the Door and Hardware Institute. She received a bachelor's degree in economics and management from Goucher College in Towson, Maryland.

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