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Step 1
Reduce portfolio volatility by trading convertible bonds. Convertible bonds are debt instruments with a coupon that pays interest. The chance to convert debt into equity buys down the rate on the coupon from a pure debt issue. The prospectus gives the exact terms of the conversion. Prospectus information can be found on the Securities and Exchange Commission corporate database website (EDGAR); links are provided in Resources. Convertible debt is usually the lowest rated debt in corporate bond issuance, ranking just above common equity.
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Step 2
Know how many shares of stock each convertible bond represents. Conversion rates are based on a premium over the stock price at the time of the bond issuance. For example, if the stock price is $20 and there is a 20 percent conversion premium, the stock conversion price is $25. Use a spreadsheet program for tracking and converting bond prices.
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Step 3
Know how to compute the conversion ratio. A $1,000 bond with a conversion price of $25 will convert into 40 shares of stock. At conversion, you will no longer receive the bond coupon, but you will receive regular dividend payments.
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Step 4
Invest in convertible bonds of companies that have significant upside. If the stock price rises to $50, the $1,000 par bond will trade at a price of $2,000 or two times par value. A stock rise from $20 to $50 would be a percentage increase of 150 percent. Companies will convert stock to remove debt and bolster their equity issues. However, the coupon debt that was tax deductible now must pay dividends from after-tax income if there is a dividend policy in place.
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Step 5
Convert the stock within the 30-day time frame provided by the issuing company. Convertible bonds are best left with your broker so the conversion process can go smoothly and you can easily dispose of the new shares should you not wish to keep them.
