CONVERTIBLE BONDS

Definition 1

A corporate bond, usually a junior debenture, that can be exchanged, at the option of the holder, for
a specific number of shares of the company's preferred stock or common stock. Convertibility
affects the performance of the bond in certain ways. First and foremost, convertible bonds tend to
have lower interest rates than non-convertibles because they also accrue value as the price of the
underlying stock rises. In this way, convertible bonds offer some of the benefits of both stocks and
bonds. Convertibles earn interest even when the stock is trading down or sideways, but when the
stock prices rise, the value of the convertible increases. Therefore, convertibles can offer protection
against a decline in stock price. Because they are sold at a premium over the price of the stock,
convertibles should be expected to earn that premium back in the first three or four years after
purchase. In some cases, convertibles may be callable, at which point the yield will cease.

Definition 2

A convertible bond is a bond that gives the holder the right to "convert" or exchange the par amount
of the bond for common shares of the issuer at some fixed ratio during a particular period. As
bonds, they have some characteristics of fixed income securities. Their conversion feature also
gives them features of equity securities.

Convertible bonds are bonds. They have a coupon payment and are legally debt securities, which
rank prior to all equity securities in a default situation. Their value, like all bonds, depends on the
level of prevailing interest rates and the credit quality of the issuer.

The exchange feature of a convertible bond gives the right for the holder to convert the par amount
of the bond for common shares a specified price or "conversion ratio". For example, a conversion
ratio might give the holder the right to convert $100 par amount of the convertible bonds of
Ensolvint Corporation into its common shares at $25 per share. This conversion ratio would be said
to be " 4:1" or "four to one".

The share price affects the value of a convertible substantially. Taking our example, if the shares of
the Ensolvint were trading at $10, and the convertible was at a market price of $100, there would be
no economic reason for an investor to convert the convertible bonds. For $100 par amount of the
bond the investor would only get 4 shares of Ensolvint with a market value of $40. You might ask
why the convertible was trading at $100 in this case. The answer would be that the yield of the bond
justified this price. If the normal bonds of Ensolvint were trading at 10% yields and the yield of the
convertible was 10%, bond investors would buy the bond and keep it at $100. A convertible bond
with an "exercise price" far higher than the market price of the stock is called a "busted convertible"
and generally trades at its bond value, although the yield is usually a little higher due to its lower or
"subordinate" credit status.

Think of the opposite. When the share price attached to the bond is sufficiently high or "in the
money", the convertible begins to trade more like an equity. If the exercise price is much lower than
the market price of the common shares, the holder of the convertible can convert into the stock
attractively. If the exercise price is $25 and the stock is trading at $50, the holder can get 4 shares
for $100 par amount that have a market value of $200. This would force the price of the convertible
above the bond value and its market price should be above $200 since it would have a higher yield
than the common shares.

Issuers sell convertible bonds to provide a higher current yield to investors and equity capital upon
conversion. Investors buy convertible bonds to gain a higher current yield and less downside, since
the convertible should trade to it bond value in the case of a steep drop in the common share price.

Investors traditionally use "breakeven" analysis to compare the coupon payment of the convertible
to the dividend yield of the common shares. Modern techniques of option analysis examine the
convertible as a bond with an equity option attached and value it in this manner.

Definition 3

Convertible securities are hybrid investment instruments, the most common of which are
convertible bonds and preferred stocks. As their names imply, they can be converted at the user's
choice into other investments, most often shares of common stock.

As a mixed breed, convertibles share the relative safety of fixed-income investments (bonds), while
also being exposed to the underlying stock's potential gains. They move in sync with the stocks into
which they can be converted, yet their hybrid nature makes them less volatile.

Like fixed-income investments, convertibles pay interest and principal payments as well as
dividends. If it's a bond -- essentially a loan -- the company has to pay back the money with interest.
If it's a preferred stock, which blends the characteristics of a bond and common share, it pays
dividends and gives the investor a leg up over common stock in making claims on a company's
assets in the event of a liquidation or sale.

Why convertible bonds?

A convertible bond is superior to convertible preferred stock because it's safer and the interest is
paid before any stock dividends. In addition, if the company goes under, a convertible bond holder
still has priority over stockholders when it comes to settling financial claims.

Investors can make money two ways: Sell the convertible when its price goes up in the market, or
convert to common stock and sell the shares.

Funds even better

Convertible securities have their place in a well-diversified portfolio, said William Harding, an
analyst at Morningstar, a mutual-fund rating and information company. But the exact percentage
that convertibles should take up in one's portfolio depends on personal investment goals and needs.

It's suggested that the best way for individual investors to participate in convertibles is to buy into a
mutual fund. Convertibles are complex securities and information about them isn't as readily
available to small investors as common stocks.

For example, when buying a convertible bond, the investor has to look at several things: The bond's
interest rate and yield, how many years remain before maturity, the common stock price applicable
upon conversion, how it compares to a regular bond, downside risk and possible rewards in
converting to a stock.
Since a bond, whether convertible or "straight" is still a loan, the investor also has to investigate the
quality of the business issuing the bond to determine whether the company can pay back what it
owes. Throw in the idea that the company may choose to repay the loan before maturity and you've
got more homework to do than you'd probably want.

The upshot? Researching a convertible carries an extra level of complexity because you have to
investigate the dual nature of this hybrid security. So stick with mutual funds, experts say.

The risks

Bonds, whether convertible or not, are only as good as the strength of the company behind it. In the
past year or so, the credit quality of convertible bonds has dropped off.

Indeed, half of the convertible market comprises issues in technology and telecommunications, both
of which can be volatile sectors.

Convertible funds also tend to be more expensive than domestic stock funds because most carry
loads, or sales charges.

And just because a fund invests in convertible securities doesn't mean it will always be less risky
than a regular stock fund.

Look at a fund's investment policy carefully. Some managers are allowed to invest a large
percentage of the fund's assets in regular stocks, and, if they are chasing performance, they most
likely will have investments in technology companies.

Definition 4

Convertible Bonds are securities that offer you the right to acquire common stock of the issuing
corporation under specified conditions rather than by direct purchase in the market. The terms at
which the security can be exchanged for the issuer's common stock are set forth in the bond
indenture. The option to convert is solely at your discretion and will only be exercised when and if
you find such an exchange desirable. New issue Convertible Bonds generally have a maturity of 5
to 30 years and offer a lower coupon rate than that of nonconvertible bonds of comparable quality.

Benefits

Enjoy the potential for appreciation of the common stock combined with relative investment safety.
If the price of the underlying common stock declines, the bond's price can be expected to fall only
to a point where it yields a satisfactory return on its value as a straight bond. You receive the
potential growth of a stock, plus the stability of a bond.
This flexible investment is available in a variety of maturities so you can choose the time frame that
works best for you.

Features

Maturities range from 5 to 30 years and can be extended indefinitely if you choose to convert your
bond to common stock.