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Ride out market ups and downs with convertible bonds

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In a roller-coaster year for the equities markets—like the one we’re having now—keeping your equilibrium is difficult. But here’s a way that seasoned investors can benefit if prices rise while securing a measure of protection if prices fall:

Strategy: Consider investing in convertible bonds. This unique investment operates much like a normal corporate bond, but—as the name implies—you can convert these bonds into the underlying corporation’s common stock tax-free.

If you sell the stock later, your gain is generally treated as a long-term capital gain, taxed at the maximum 15 percent federal rate.

Here’s the deal: A convertible bond resembles an ordinary corporate bond in that it has a fixed interest rate and date of maturity. The bond is a debt of the corporation that issues it, so it must be paid regardless of earnings.

Key difference: You can exchange convertibles tax-free for a predetermined amount of stock in the corporation.

With a convertible bond, you benefit from a comparable upswing if the stock price rises, but you don’t face the same level of risk if the stock drops. That’s because convertibles have a built-in safeguard: When the common stock is selling below the conversion price, the bond won’t sell for any less than its value as a bond. Either way, you win.

That’s not to say that convertible bonds are without any minuses. Keep these points in mind:
  • Convertibles typically have a lower yield than comparable corporate bonds because of the conversion privilege.
  • For certain convertible bonds, the value of the common stock you will receive on exchange is low, so it will be years before the conversion privilege is worth much.
  • With other convertibles, the price of the common stock may be high, so you must pay a hefty premium for the conversion privilege. If the stock falls precipitously, you might lose roughly the same amount as if you owned the stock outright.
  • Most convertibles can be “called” on short notice. The issuer is unlikely to allow the stock price to climb way above the conversion price, limiting your profit potential.
  • Tip: Convertibles are best left to sophisticated investors. Stick to plain vanilla debt or equity offerings if you feel that you’re out of your league.

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