Investing in convertible securities
Tap into a security’s upside potential with a component of downside protection
For many investors, convertible securities remain an unknown or they get overlooked when it comes to asset allocation. However, these hybrid vehicles offer a mix of potential benefits that can appeal to both fixed-income and equity investors. The structure of convertibles can help preserve capital, reduce volatility with the bond component, and capture upside potential from an equity conversion.
They’re typically issued as bonds or preferred stock that can later be converted to a specific number of common shares. That means you may benefit from both the income and downside protection inherent in the fixed-income portion and from any potential price appreciation of the underlying common stock. In short, they offer a defensive way to participate in equities.
Potential Investor Advantages
- A company’s convertibles are typically less volatile than its common stock, providing upside participation should the stock price rise and downside protection should the stock price fall.
- While past performance is not a guarantee of future results, long-term studies show that convertibles have historically produced near-equity returns with lower risk, making them an effective tool for portfolio diversification.
- Most convertibles feature what’s called yield advantage. That means they may pay a fixed income stream that is typically greater than the dividend yield a common-stock shareholder would receive.
- Because convertibles are higher ranking than common shares within the company’s capital structure, you’ll have unsecured claims on assets and receive a higher recovery value in a bankruptcy or liquidation relative to common shareholders.
- Convertibles can help investors participate in the growth of innovative companies while potentially reducing portfolio volatility.
To determine whether convertible securities are right for your overall financial strategy and to discuss any risks involved, please contact your financial advisor.
Addressing Risk
All investments involve risk. Convertibles are no exception. Discuss these points with your advisor before investing. Market risk is the prospect that the price of the convertible will decline if market conditions change (e.g., interest rates, credit quality, liquidity or the value of the underlying common stock). Reinvestment risk is the possibility that coupon payments will be reinvested at a lower rate. Call risk is the chance the issuer will call the convertible prior to maturity and/or at a price below your purchase price.
Liquidity risk reflects the possibility that inadequate demand might hinder selling the convertible in a timely fashion at an acceptable price. Dividend risk is the prospect that the issuer reduces or suspends the common-stock dividend so that the convertible’s yield no longer meets its objective. Most convertibles are issued with provisions that require the company to adjust the conversion ratio or pay additional interest to compensate holders should the dividend increase.
Takeover risk is the possibility that another company will acquire the issuer, which may change the conversion terms and options. This can also result in a change in the issuer’s financial makeup. Default risk stems from the likelihood of the issuer becoming insolvent and unable to repay bondholders their principal or make periodic coupon payments. Currency risk applies to convertibles denominated in a foreign currency.
Taxation risk involves a wide range of potential income-tax implications depending on structure and issue. In some cases, investors may be taxed on a larger portion of income than they actually receive. Diversification and asset allocation do not guarantee a profit or protect against loss.