Guides for new investors tend to describe bonds as a dowdy step-sister to the stock market's sexy femme fatale. They're depicted as safe but unexciting. That characterization is broadly true, but it's far from the whole picture. Speculative high-yield bonds can be just as risky as stocks, and convertible bonds can be an interesting hybrid of stock-market excitement and bond security. They hold the potential to provide yields in both good times and bad.
How They Work
All bonds are basically IOUs. The issuer promises to pay you a set rate of interest in exchange for your loan. Convertible bonds throw a new wrinkle into this formula since you can convert those bonds into the company's common stock. Each bond you own entitles you to buy a predetermined number of shares, a proportion called the "conversion ratio." Stocks must rise by a given percentage to be worth what you'd pay by converting, which creates a "conversion premium." The relationship between your conversion ratio, the conversion premium and the stock price determines how you make a profit.
In Up Markets
Every bond pays a coupon rate, or the annual interest at a specific percentage. It's lower on convertible bonds because you're buying the chance to make extra money when the stock grows. For example, say a $100 bond lets you buy five shares at $15 each. The stock's price has to grow by a third before you'd break even on the conversion, so it's got a 33 percent conversion premium. The stock is considered "in the money" if it rises above $20. Once it's at a level you're happy with, you can convert it to stocks, sell them, and take the profit.
In Down Markets
A decline in the value of the issuer's common stock will hurt a convertible bond too. You'll still have your coupon interest to offset that, so you won't take as much of a hit as you would if you'd invested in the stock directly. When you're shopping for investments, convertible bonds hobbled by low stock prices can be a bargain. It'll be worth a set amount -- typically $1,000 -- when it matures, so if you get it at a bargain-basement price you'll make a pretty good return. There's also a chance the stock will rise again.
Of course, there's no such thing as a free lunch in the investment world, and convertible bonds have their limitations. For example, the issuing company might specify you can't convert until the stock has been above a certain price for a set length of time. On the other hand, you might be forced to convert at a given price. Either option can nudge you out of a profit. Some are callable, which means the company can buy them back from you before you exercise your conversion rights. The company also has to stay in business, otherwise your bond is worth little or nothing.