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Ride out stock market ups and downs in a convertible

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in Small Business Tax

Every year, it seems like the stock market is a roller coaster. It’s pretty hard to keep your equilibrium. But there’s a way that savvy investors can aim for the best of both worlds: an uptick if prices rise and some protection if prices free-fall.

Strategy: Consider the pros and cons of convertible bonds. This unique investment operates much like a corporate bond, but—as the name implies—it includes a conversion feature. Specifically, the bonds can be converted into the underlying common stock of the corporation without any current tax consequences.

If you later sell the stock, your gain generally is treated as a long-term capital gain, currently taxed at a maximum 15% rate (scheduled to increase to 20% in 2011).

Here’s the whole story: 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 whether there are earnings or not. Key difference: Convertibles can be exchanged tax-free for a predetermined amount of stock in the corporation.

With a convertible bond, you theoretically benefit from a comparable upswing if the price of the stock goes up, but you don’t face the same level of risk if the stock goes down. 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 might win (see box below).

But that doesn’t mean that convertible bonds are without their drawbacks. 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 have to 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, so it limits your profit potential.

Tip: Convertibles are best left to sophisticated investors. Stick to “plain vanilla” equities if you feel that you’re out of your league.

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