Q: Wouldn't a convertible bond be a preferable fixed-income investment compared to a standard bond because of the upside potential?
Convertible bonds may seem like great deals -- after all, you get predictable income and the potential to profit if the issuing company's stock price increases. However, there are some drawbacks you should be aware of.
Perhaps the biggest downside is that convertible bonds generally pay significantly lower yields than comparable fixed-income securities. This is one of the main reasons companies issue convertible debt -- it keeps their borrowing costs lower than they otherwise would be. For example, if corporate bonds of a certain rating pay 5% annual interest, a company with that credit rating might be able to pay just 3% -- or even less -- on convertible debt.
Of course, if the company's share price soars and converting those bonds into common stock becomes a profitable choice, that won't be an issue for you as an investor. However, if the stock performs poorly, you'll be stuck with a low-paying fixed-income security.
It's also important to realize that issuing companies generally have the right to force the conversion of their bonds if the stock price is higher than the conversion rate. In simple English, companies only allow convertible bonds to rise by a certain amount -- then they'll become stocks. So, if you aren't careful, buying convertible bonds can result in you have a higher stock allocation in your portfolio than you intended.
Finally, because their values are somewhat derived from the stock's price, convertible bonds tend to be far more volatile than conventional bonds.