A convertible investment is the type of financial instrument that carries the option to convert into another financial tool. Most common convertible investments are Bonds and Preferred Stocks. The convertibility feature enables these to convert into Common Stocks of the issuing company at the predetermined terms and conditions.
Risk tolerance differs from one investor to another. Investment pattern is influenced by age, income, stage of life, disposable income, risk taking capabilities and so on. Based on the Risk-Return trade off, there are different kind of instruments that offer investment solution to the wide variety of investors. Between the risk free bonds in one end and completely risky equity on the other, different financial instruments like the plans with convertible features are available that provide different investment choices for many investors.
Following points discuss the pros and cons of these instruments that make these viable options as savings tools.
This essentially is a hybrid of debt and equity. A convertible bond can be exchanged into common shares in a predetermined ratio as decided at the time of issuing.
Main features if Convertible Bonds are:
- Conversion of bonds to common stocks is non-taxable, and it is independent of the fair market value of the stock during conversion.
- Being essentially a bond, it has a lower volatility and higher safety than the corporate common stock.
- At the same time, it gives a regular interest income, though its coupon rate is lower than regular corporate bonds. For example, if regular bond gives 6.45% interest rate, the convertible bond gives less than 3%.
- Investors have the advantage of converting this to Common stock while company’s stock price goes up
- In case conversion option could not be executed, still the investor gets the regular cash flow from interest payment and the return of principal upon maturity
Considering the above criteria, the investors who want to invest long term and opt for a regular inflow of money from their investments with a brighter earning potential of conversion to high performing stocks find this instrument as a viable saving option. This is a good compromise between risk and return.
Caution for Convertible Bond:
- Though it gives better safety to investors in bear market, in the rare case scenarios where the issuing company becomes insolvent and goes into bankruptcy, convertible bonds are penalized since they are paid after the company pays its corporate bonds.
- So credit quality and the growth potential of the issuing company needs to be analysed
These are the preferred stocks that can be converted into common stocks as of a predetermined date at a specified ratio. Preferred stocks are generally paid after company’s bond and this also generates a regular dividend but next in priority after corporate bonds. Moreover, Proffered stocks get dividend out of company’s profit but not from cash flow. So, to make the preferred shares more attractive to investors, convertibility feature is added. This gives the option to convert them into a specified number of common shares, after a predetermined date.
Main features if Convertible Stocks are:
- If the common shares rise in value, this feature is attractive
- If you want initial low risk but a higher return if company performance is better than expected, then preferred stock is the option
- Preferred stocks have an upper limit of stock price. But if it convertibility is added, then this limit will not be valid. This will give benefit when the company’s stock goes up. In that situation, a good capital gain is possible for preferred stocks with convertibility.
Caution for Convertible Preferred Stocks:
- However, in case of liquidating or bankruptcy of the issuer, Convertible preferred stock ranks below convertible bonds. So there is more uncertainty of getting back money compared to convertible bonds.
- Also, the information about preferred stocks (as well as convertible versions) is limited or unavailable at times in the market. This makes the purchase of these instruments difficult.
From the preceding discussion, we get the different aspects of the advantages and disadvantages of Convertible instruments to be included in the portfolio as a viable saving option. While considering the convertible investment plans as probable saving options, investors need to:
- define their individual positions and suitability of the hybrid instruments in their portfolio based on its own risk and reward potential.
- Do a careful analysis of the issuer’s business position and growth potential as well as the features offered for the considered bonds and securities before investing.