What Is a Convertible Stock?
A convertible stock is a stock that can one day be converted into that company's common stock. By purchasing a convertible, you're purchasing a predetermined amount of stock in the company later. For instance, a conversion rate of 20-to-1 means that for every convertible share purchased, the owner can convert it into 20 shares of common stock later.
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Objectives
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According to investopedia.com, this stock is best when you're seeking capital appreciation of an investment. The convertible stock can also be useful when you're trying to protect the original investment. The intent isn't necessarily to produce great income. By purchasing this type of stock, you're acquiring the right to convert this stock later, thus earning the stock's capital gains.
Risk
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The biggest risk is that a convertible stock is what's called a callable stock. This would usually happen if interest rates dropped, forcing the stock issuer to recall the stock and reissue it at a lower rate. In the case of this stock, the issuer would turn the convertible stock into a common stock without the owner's approval. It's considered a forced conversion. The best way to avoid this when buying a convertible stock is to purchase stock in companies that feature a convertible stock with a low premium.
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Strengths
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It's hard to lose money because the original investment cannot dip below the stock's market value. The convertible holds its value until conversion. Convertibles allow those building retirement portfolios the chance to purchase these stocks for their tax-deferred retirement plans. And it's a solid investment when interest rates are high and the market is low.
Weaknesses
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Along with the forced conversion mentioned earlier, the return on this type of stock is quite low, which is why many consider convertibles a safe investment. It may not make much money, but chances are it won't lose much money, either.
How To Get It
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A traditional stockbroker can help you buy convertible stock. Most convertible stocks go for $1,000, which is the going price for one bond. The conversion rate into common stock varies, so read the fine print on your purchase agreement.
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