How to Analyze Convertible Bonds
Convertible bonds represent solid investment opportunities for investors needing both income and a claim to equity market appreciation. Convertible bonds pay interest until either the holder or issuer convert the bonds into a predetermined number of common stock shares. Convertible bonds provide stability in market value, making them a good balance of equity and debt.
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Instructions
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Buy convertible bonds for capital gains and income. Convertible bonds typically have a 10- to 30-year maturity with stock appreciation possibilities. Compute the value of bond portion of the investment. Determine the market yield of a similar bond without equity convertibility. Use the coupon from the convertible bond and a bond calculator to price the nonconvertible debt. This resulting value is the market value of the bond portion of the convertible. The difference between the bond portion and the purchase price is the equity value.
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Know how many shares of stock each convertible bond is eligible for conversion. Learn the conversion price per share. Usually it is expressed as the number of shares per $1,000. Read the indenture or contact the issuer of the bond for the exact terms of conversion. Conversion is usually prohibited the first few years after issuance though the price of the bond will still be affected by stock price fluctuations.
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Understand the credit risk of convertible stock. Learn how the security for the bond is subordinated. Subordinated stock means what other senior debt has a higher claim on assets. Know that common stock is junior to all other corporate debt. Buy convertible bonds only of strong, healthy companies for capital gains and income.
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Hold the convertible bond until you believe the stock price has peaked. Consider selling the bond at this time. Be aware that at some point the company will either call the bond or force conversion of the bond into stock. This will occur if the stock price rises greatly or if the bond coupon greatly exceeds the stock dividend. Contact your broker with your sell or conversion decision before the mandatory call date.
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Consider the use of convertible bonds in retirement accounts to accrue interest. Not all companies have outstanding convertible issues. Consult your tax professional for tax implications of converting particular to your own tax situation. There isn't a tax effect generated by the conversion. Tax events occur when the convertible bond or the converted stock is sold.
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Tips & Warnings
There are many arbitrages that investors and traders use convertible bonds for.
Convertible bonds allow many option hedging strategies.
The priority decision in buying convertibles should be whether the underlying stock is expected to rise in value.
The coupon payment should be greater than the dividend.
