The huge gains in the stock market over the past five years have investors nervous about the potential for a correction or bear market in the future. Yet with traditional conservative investments like bank CDs, investors have to accept rock-bottom interest rates that aren't even enough to offset the impact of inflation. What many investors want is something that will pay them a reasonable amount of income while also giving them some potential upside if stocks keep climbing. In response, many are looking at convertible bonds as a possible way to get the just-right exposure to the stock and bond markets that would make Goldilocks proud.
What the heck are convertible bonds?
As the name suggests, convertible bonds are structured as fixed-income securities, with bondholders having the right to collect interest payments until the bond matures. At maturity, bondholders can elect to get their principal investment back, just as with a regular bond.
But the big distinction that gives convertible bonds an extra kick is that they give bondholders the right under certain circumstances to convert their bonds into shares of the issuing company's stock. Although some convertibles force investors to accept shares down the road, many simply give bondholders the option to convert. In the latter case, you can get the best of both worlds. If the stock rises, then you convert and reap much larger returns as a result. If the stock falls, you still have the right to your principal when the bond matures.
The challenge of investing in convertible bonds
The biggest hurdle for investors looking at convertible bonds is that buying them isn't as easy as making a stock trade on a popular company. The bond market is notoriously illiquid at the individual-investor level, and even if you look for other types of convertible securities, such as convertible preferred stocks, you'll often find very few buyers or sellers looking to trade them at any given time.
Many investors who want exposure to convertible bonds therefore turn to mutual funds and exchange-traded funds. Over long periods of time, top-performing funds like Vanguard Convertible Securities and Fidelity Convertible Securities have produced solid returns that approach what stocks have returned, but with the promise of slightly less volatility than simply investing in the stock market directly would entail.
Know the risks of convertible bonds
Even though they provide both income and potential for growth, convertible bonds aren't risk-free. In particular, you have to look closely at each individual convertible bond and the company standing behind it to ensure that it's creditworthy. Also, the relationship between the current price of the stock and the price specified in the bond for conversion is especially important.
If the conversion price for the convertible bond is much higher than the current stock price, then it will trade more like a regular bond. That's because the possibility that the stock will climb high enough to trigger the conversion option is relatively low, making it worth only a small amount.
But if the conversion price is far below the current stock price, then the bond will often trade in line with the underlying stock. The bond component of the convertible will provide some downside protection if the share price falls dramatically. Yet the further the stock has risen compared to the conversion price, the further it will have to fall before that downside protection starts to assert itself.
The other thing investors should keep in mind about convertible bonds is that they've also benefited from the bull market in bonds over the past 30 years. If interest rates start to rise, then the value of the bond component of the convertible bond will erode. Again, the ability to convert the bond into shares of stock could cushion any price declines compared to traditional bonds without a conversion option.
All in all, convertible bonds are worth looking at as a middle ground between stocks and regular bonds. They won't necessarily protect you if both the stock market and the bond market fall in concert. But for those who think that stocks are too hot and bonds are too cold, convertible bonds might be just right.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.