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Ride out market ups and downs with convertible bonds

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in Small Business Tax

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, so your profit potential is limited.

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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